The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The SEC’s conflicts minerals disclosure rules, promulgated as required under provisions of the Dodd-Frank Act, became effective on January 1, 2013, requiring companies to make their first conflict minerals disclosures on or before May 31, 2014 for the 2013 reporting year, as I detailed in a recent post. But though it is widely recognized that the conflicts minerals disclosure requirements impose challenging compliance requirements on reporting companies, many companies have yet to commence their efforts to be prepared for the reporting deadline. In addition, there is some suggestion that the very existence of the requirements may be having the perverse effect of exacerbating the conditions that the disclosure requirements were intended to address.

 

The conflict mineral disclosure requirements are intended to identify the use in manufactured products of certain specified minerals from the Democratic Republic of Congo and adjacent countries. The four specific conflict minerals are tin, tantalite, tungsten and gold (the so-called 3TGs). The minerals are found in many high tech products. For example, tantalite is an essential part of most cellphones. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia (the “Covered Countries”)

 

On a positive note, some companies are in fact undertaking aggressive efforts to try to be able to determine whether its parts suppliers on rely on conflicts minerals. For example, as described in an April 15, 2013 post on the New York Times Bits blog (here), Hewlett-Packard has identified ore smelters around the world that are identified with its products in order to enable its part suppliers to ensure that their minerals were not obtained from conflict zones. (H-P’s April 15, 2013 announcement regarding the ore smelters can be found here.) H-P intends to rely on a third-party to audit the smelters documentation as a way to monitor the possible presence of conflicts minerals.

 

However, a recent article in the Wall Street Journal suggests how difficult it may be for companies to rely on documentation to monitor their parts suppliers’ compliance. In an April 14, 2013 article entitled “Inside Congo’s Link in the Gold Chain” (here), the Journal showed how easily smugglers are able to obtain false documentation for gold smuggled out of the DRC. Smuggler networks ferry gold out of the DRC to neighboring counties (such as Uganda or the South Sudan), where it is recertified and then flown to key entry points around the Middle East (particularly Dubai). As the Journal notes, “the faint paper trail disappears as soon as it arrives in Dubai.” In Dubai, the smuggled minerals are mixed into scrap bars, which are then sold for cash or smuggled into other countries.

 

Even worse, these highly profitable smuggling operations may be a direct result of the new disclosure requirements.  The disclosure requirements are built on the belief that if minerals’ source of origin is identified and disclosed, buyers can avoid minerals from the conflict regions. Because the flow of minerals is helping to finance the conflict within the DRC, the hope is that reducing the global market for the minerals will create incentives for peace there. However, as the Journal article shows, “the opportunities for illicit gains only increased” after Congress created the disclosure requirements with the Dodd-Frank Act. The smugglers’ potential profits are significantly boosted because the new disclosure requirements have “squeezed the legitimate market for the Congolese minerals.” Perversely, the requirements could actually increase the profits available for those trading in the conflict minerals.

 

Just to add to the confusion, the SEC’s conflicts minerals disclosure rules have been challenged in the courts. As I discussed previously, on October 19, 2012, the U.S. Chamber of Commerce and the National Association of Manufacturers filed a petition for review with the Court of Appeals for the District of Columbia requesting that the SEC’s rule be set aside in whole or in part. The challenge remains pending.

 

As if that were not enough, the situation could be even further complicated with the introduction of additional conflicts minerals rules from other countries and organizations. For example, Canada and the European Union are both considering new disclosure requirements that may differ from the U.S. requirements. The requirements under consideration in Canada could be broad than those in the U.S. and could include additional countries and minerals, raising the possibility of overlapping yet inconsistent rules, which has the potential to create confusion and inefficiencies.

 

With all of the murkiness surrounding the situation, many companies are slow of the mark in getting ready to meet the new disclosure guidelines. As discussed in an April 16, 2013 Compliance Week article (here), a recent PwC survey determined that many company have “intentionally delayed” conflicts minerals compliance efforts. Though of course there are companies (such as H-P) that are actively working to be able to meet the initial disclosure mandates, many other companies are, according to the PwC study, are “playing the waiting game.” Nearly 17 percent of respondents in the PwC survey “haven’t done much or are waiting to see what happens” with the legal challenge. As noted by a PwC representative in the article, “waiting until the legal challenge is resolved to begin compliance efforts is a huge gamble and n unwise approach.” There is a real concern that “many companies are getting too late a start to adequately meet the May 2014 deadline.”

 

In short, the landscape surrounding the conflict minerals disclosure requirements is fraught with peril. On the one hand, companies taking a more passive approach run a significant risk of being unable to meet the initial disclosure deadline. On the other hand, murky and potentially changing or conflicting requirements make it difficult for the companies to proceed efficiently. And finally, the complex and uncertain circumstances surrounding the global distribution of conflict minerals present significant challenges for all of the process participants to make the source of origin determinations that underlie the disclosure requirements mandate.

 

In other words, there is a great deal of risk surrounding the new disclosure requirements. The murkiness and confusion surrounding the requirements and the challenging nature of the compliance obligations suggest that, unless the courts set the requirements aside, the conflicts mineral disclosure requirements will become an increasing source of concern as the first disclosure deadline approaches.

 

I expect that conflicts minerals disclosure is going to an increasingly important source of comment and concern in the months ahead.

 

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As I detailed in recent blog posts (here and here), these days virtually every public company M&A transaction is likely to involve M&A-related litigation. For that reason, M&A litigation represents a significant liability exposure for directors and officers of the companies involved in the M&A transaction and they have a keen interest in taking steps to try to reduce that exposure.

 

These concerns are the topic of a new paper from Chubb entitled “Director Liability Loss Prevention in Mergers and Acquisitions” (here). The paper was written by D&O maven Dan Bailey of the Bailey and Cavalieri law firm. (Readers know that The D&O Diary is a big fan of Dan’s; we recently published a guest post by Dan on Cyber Liability issues.) The paper “reviews the basic legal duties of directors in this context and summarizes many loss control procedures for directors when addressing a proposed M&A transaction.”

 

The paper notes at the outset that directors “are routinely rewarded” for their hard work on a proposed M&A transaction “by being sued.” The shareholder plaintiffs “typically allege the directors acted improperly in investigating, negotiating, approving, rejecting or disclosing the acquisition transaction, regardless of how thoroughly and prudently the directors acted.”  Though the lawsuits cannot be prevented, “directors can increase the defensibility of those lawsuits and improve the quality of their decision-making process with respect to a proposed acquisition by anticipating and implementing various loss prevention practices.”

 

The paper outlines the basic legal principles that define the standard of conduct for directors of the target company. The paper then goes on to outline the steps directors can take to try to manage their liability exposure. Among other things, the paper states that “directors should create a record demonstrating that they carefully and thoroughly considered relevant information regarding the proposed transact.” Directors should also “obtain advice from experienced, qualified and independent experts in each of the relevant substantive areas.” In addition, “only independent and disinterested outside directors should act on behalf of the company with respect to the proposed transaction.” In addition, “directors should seek to obtain the best value available for the company,” in the specific ways that the paper enumerates. Finally, the company must manage the timing and content of its disclosures of the transaction in order to try to minimize disclosure-related risks.

 

There are also a number of transaction-related pre-litigation strategies the company can implement to improve the companies ability to defend the inevitable litigation. These include, among other things, amending the by-laws to designate a specific jurisdiction as the exclusive venue for shareholder suits involving governance issues; retaining qualified defense counsel in advance of the transaction; develop an external communication protocol to reduce disclosure –related risks; and the provision of detailed directors training in anticipating of the takeover process, including the “likely sequence of events, recommended governance practices and various best practices related to the proposed transaction.”

 

Finally, the paper reviews the indemnification and insurance issues relevant in the M&A context.  Among other things the paper discusses the need for the target company to have in place prior to the closing “a prepaid, noncancelable, extended run-off policy that cannot be amended or affected in any way by the acquiring company or subsequent management.”

 

Another M&A related insurance topic that the paper does not discuss is the possible need for representations and warranties insurance protection. Readers may be interested to note that the Professional Liability Underwriting Society (PLUS is hosting a webinar on Tuesday March 19, 2013 at 11:00 am EDT on the topic of Representations and Warranties insurance coverage. Information about this free webinar can be found here.

 

D&O Year in Review: Once again, my good friends at Troutman Sanders have published their annual roundup of D&O insurance coverage decisions. The publication, which is entitled “D&O Professional Liability: A Year in Review,” which provides a comprehensive overview of coverage decisions from the world of D&O in the last year, can be found here.

 

Board Minutes: I recently was asked to attend a meeting of the board of directors of a large financial institution client. While I was in the meeting, one director asked my views about board meeting minutes: should the board minutes be very detailed? Or should they be bare-boned? Which was better from a risk management standpoint? From the way the director asked the question, I knew that that was a topic on which he himself had strong views, and his manner also suggested that this topic was an issue of some debate at the board level. I looked across the table to the company’s general counsel, to see how I should handle the question. Her face said “Don’t throw me under the bus.” So all I said was that the question of board minutes is an important topic that should be discussed with your in-house counsel and if needed your outside counsel.

 

The question about the appropriate level of detail in board minutes is a recurring question. There is, in fact, no single right answer. The correct answer will vary, depending on the age and size of the company, as well as the advice of the company’s counsel. There are a number of important considerations to keep in mind, which are reviewed in a March 6, 2013 JD Supra Law News article written by Stephen Honig of the Duane Morris firm and entitled “Director Liability: Corporate Minutes as Trojan Horse” (here). The article reviews the liability issues that may arise from the board minutes and also reviews how the ground rules change as companies mature and grow larger. The article reviews the legal touchstones and lays out the basic ground rules. The article concludes by saying that directors “should remember that they are protected if they utilize robust process in the board room and are well-served if they document that process.”

 

Is a Pending Appellate Decision Interpreting Morrison Off the Docket?: For some time, we have been awaiting a ruling from the Second Circuit in the hedge fund claimants’ appeal of a district court dismissal of their action against Porsche and certain of its directors and officers. The hedge funds, which had shorted Volkswagen stock in the belief that its share price would fall, claimed that Porsche misled investors by denying through much of 2008 that it intended to acquire VW. Porsche later disclosed that it had been positioning itself to acquire the company.

 

As discussed here, in a December 30, 2010 ruling, Southern District of New York Harold Baer granted the defendants’ motions to dismiss. In granting the motion, Baer relied on the U.S. Supreme Court’s decision in National Australia Bank v. Morrison. Judge Baer found that because the securities underlying the swap instruments the hedge funds had acquired were traded on the German stock exchange, acquiring the swaps was the “functional equivalent of trading the underlying shares on a German exchange."

 

The hedge funds filed an appeal of Judge Baer’s dismissal. As discussed here, while the appeal was pending, the Second Circuit issued a ruling in the Absolute Activist Value Master Fund case interpreting Morrison’s application to non-exchange traded securities. The court held that in order to pursue a securities claim in connection with a transaction in non-exchange securities, the claimant has to allege either “irrevocable liability was incurred or title transferred within the United States.” I noted at the time that the Absolute Activist Value Master Fund case The Second Circuit’s holding in the Absolute Activist Value Master Fund case, in which the Second Circuit said among other things that the identify of the securities involved in the transaction is not determinative, would seem to suggest that the district court’s holding in the Porsche case may not withstand scrutiny on appeal.

 

Ever since the Second Circuit issued its ruling in the Absolute Activist Value Master Fund case, observers have been awaiting the Second Circuit’s ruling in the Porsche case. However, on March 6, 2013, Bloomberg reported (here) that the hedge funds have filed a motion to withdraw their appeal in the Porsche case. The Second Circuit must grant the motion to withdraw, but assuming it is granted, it appears that the appeal would be withdrawn, meaning that the lower court dismissal of the case would stand. The Bloomberg article notes that four cases against Porsche and certain of its directors and officers remain pending in Germany. It appears that the hedge funds may have decided to focus their efforts on the Germany cases.

 

In any event, if the Second Circuit grants the motion to withdraw, the long-anticipated resolution of the hedge funds’ appeal of the dismissal will not be forthcoming. That would mean at a minimum that the Absolute Activist Value Master Fund ruling will continue to represent the standard for securities cases involving non-U.S. entity defendants whose shares do not trade on U.S. exchanges.

 

I can’t help having a “that’s too bad” reaction. I have been looking forward to seeing what the Second Circuit was going to do with the appeal in the Porsche case.

 

One Director Defendant in Latest FDIC Failed Bank Suit: As the FDIC has been ramping up its litigation against the directors and officers of failed banks, one of the things that has been hard to figure is how the agency decides who it is going to sue. Sometimes it files cases only against former bank officers, sometimes it includes director defendants. And now in the latest case to be filed, the FDIC has filed a suit against only a single director defendant. However, in this case, there is some information available to explain why the one director was the only defendant.

 

On February 22, 2013, the FDIC, acting in its capacity as the receiver of the failed Carson River Community Bank, filed an action in the District of Nevada against James M. Jacobs, a former director of the bank. A copy of the FDIC”s complaint can be found here. Regulators closed the bank on February 26, 2010, which means that the agency filed its compliant just before the third-year anniversary of the bank’s closure. The sole defendant is described in the complaint as the co-founder and as a stockholder of the bank, as well as a director in the bank. Importantly for purposes of the suit, the complaint also states that Jacobs also had ownership interests in certain Oklahoma banks that participated in some of the loans that the FDIC referenced in the complaint.

 

As detailed in a March 1, 2013 memo by W. Bard Brockman of the Bryan Cave law firm (here), according to the FDIC’s complaint, the three subject loans were participated out to two Oklahoma banks owned by Mr. Jacobs’ family and for which Mr. Jacobs served as a director. The other directors on the Senior Loan Committee knew about Mr. Jacobs’ interest in the participating banks, but they did not know that Mr. Jacobs allegedly had secretly arranged for the Oklahoma participating banks to have preferential rights to repayment upon default. The Oklahoma banks were ultimately paid in full and Carson River Community Bank sustained most of the loss on the loans. This conduct, the FDIC alleges, constituted a breach of Mr. Jacobs’ fiduciary duty to Carson River Community Bank.

 

Brockman speculates that there may be an additional reason why the other loan committee members were not named as defendants because “Nevada has a very forgiving standard of liability for corporate directors. Under the Nevada corporate code, a director is not liable unless it is proven that: (a) the director’s act or failure to act constituted a breach of his fiduciary duties; and (b) the breach of those duties involved intentional misconduct, fraud or a knowing violation of law.” Brockman suggests that the FDIC must not have had sufficient facts to support an allegation that the other directors had committed “intentional misconduct, fraud, or a knowing violation of the law.” Brockman concludes by noting that this case is “a true factual outlier and it does not signal a trend that the FDIC will target single director defendants.”

 

A Break in the Action: For the next few days, I will be traveling overseas on business. The D&O Diary’s publication schedule (such as it is) will be disrupted for the next few days. I hope to resume the normal publication schedule during the week of March 18, 2013.

 

And Finally: A recurring topic of interest to everyone here is the question of why The Netherlands is sometimes referred to as Holland. This topic is amusingly explained in the accompanying video (with more information on the topic than you might have thought possible). Enjoy. (Sorry about the short commercial at the beginning.)

 

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Although I was aware that among the Dodd-Frank Act’s hundreds of pages are provisions relating to so-called “conflict minerals,” until recently I had not had to pay much attention to these provisions. But now, for whatever reason, the conflict minerals disclosure requirements suddenly have hit the center of my radar screen. I have had to do a lot of backing and filling on the topic. Because I think we are all going to have to become familiar the conflict mineral disclosure requirements, I have summarized what I have learned below

 

First, some background. Section 1502 of the Dodd Frank Act required the SEC to promulgated rules requiring companies to annually disclosure their of conflict minerals originating in the Democratic Republic of Congo (DRC) or an adjoining country. On August 22, 2012, the SEC adopted the conflict mineral disclosure rules. The SEC’s August 22, 2012 press release can be found here and the rule itself can be found here.

 

The specific minerals at issue are tantalum, tin, tungsten and gold. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia (the “Covered Countries”)

 

The rule applies not just to companies with SEC reporting obligations (including both domestic and foreign issues) but. It also applies to any company that uses the specified minerals if the minerals are “necessary to the functionality or production” of a product manufactured by or “contracted to be manufactured” by the company.

 

Companies are required to comply with the new disclosure rules for the calendar year beginning January 1, 2013, with the first disclosures due May 31, 2014 and subsequent disclosures due annually each year after that. However, a legal challenge to the rules has been raised. On October 19, 2012, the U.S. Chamber of Commerce and the National Association of Manufacturers filed a petition for review with the Court of Appeals for the District of Columbia requesting that the SEC’s rule be set aside in whole or in part.

 

While the legal challenge remains pending, many companies are readying themselves to comply with the rule. Basically, the rule requires disclosure by a public company if it manufactures (or has others manufacture) a product that includes a conflict mineral. If a company determines that its product has a conflict mineral, the company must conduct a good faith inquiry to determine if the mineral is derived from mining in one of the Covered Countries. If the company determines that the minerals came from one of the Covered Countries, it must then file a Conflict Minerals Report on Form SD.

 

Among other things, companies filing a Report must conduct due diligence efforts (using an internationally recognized framework, such as the OECD Due Diligence Guidance) to determine whether the operations in the Covered Country helped finance armed conflict. If the minerals are conflict free, the company must certify that conclusion with an independent audit. If the minerals are not conflict free, the company must disclose the information relating to its use of the conflict minerals. For companies unable to determine whether or not the minerals are conflict-free, the company can declare itself “conflict indeterminable” during a two-year grace period (four years for smaller reporting companies).

 

Notwithstanding the legal challenge, and though the first reporting deadline is still more than a year away, many companies are now scrambling to try to adapt to these reporting requirements. As Barbara Jones of the Greenberg Traurig firm wrote in a March 5, 2013 Law 360 article entitled “Sharpen Your Pencils for Conflict Minerals Disclosures” (here, registration required), reporting companies are “forming high-level internal compliance teams with representatives from legal, finance, internal audit and purchasing involved to assess the extent, if any, that the company’s product contain conflict minerals.” The efforts, she notes have extended to “supply chain participants” who are not “deeply involved in determining and certifying the original source of supplies of tantalum, tine, tungsten and gold (3TGs) and their numerous derivatives, sold to their customers.”

 

There is a lot of risk here for the companies involved. First and foremost, companies face a serious potential PR risk. Companies found to be out of position on conflict minerals will undoubtedly face a publicity firestorm from humanitarian groups and activist investors. Although it remains to be seen, adverse publicity could prove to be a problem not just for companies that must declare their use of conflict minerals but even for those that are unable to declare themselves conflict mineral free.

 

As with any disclosure requirement, there is also a significant litigation risk as well. Companies compelled to reveal their use of conflict minerals could well be the target of shareholder suits. A particularly difficult problem would involved companies that had declared themselves to be conflict free that are later shown have been using conflict minerals after all. The negative publicity and likely share price decline would undoubtedly be followed by a securities class action lawsuit. Activist shareholders could also launch derivative suits against companies based on allegations such as the failure to implement adequate procedures to ensure that the company’s products were conflict mineral free.

 

Of course, whether any of these kinds of suits actually emerge remains to be seen. But though these potential dangers remain off in the future, and though the first reporting deadline is more than a year ahead, the present challenge for reporting companies is to be prepared now for these coming tests. I also anticipate that in coming months, questions surrounding companies’ preparations for the conflict minerals disclosure requirements increasingly will become a part of the D&O insurance underwriting process.

 

As a final note, I should stress that in my description above I simplified the conflicts minerals disclosure requirements. Readers who want a deeper understanding may want to visit the Conflict Minerals Resource Center on the website of the Schulte Roth law firm. The site has a number of helpful links and articles.

 

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I recently had a meeting with the board of a publicly traded company. Among the topics I knew that I would be asked to address at the board  meeting is the growing risk of cyber liability. In my preparation for the board meeting, I came across a recent article by D&O maven Dan Bailey, a partner in the Bailey Cavalieri law firm, entitled "Cyber Risks: New Focus for Directors" which talks about companies' growing cyber liability exposures and directors' roles as companies try to address these exposures. I found Dan's article so helpful that I contacted him to see if he would be willing to publish the article on this site. I am pleased to report that Dan agreed to allow me to publish the article, which is reproduced below. 

 

I would like to thank Dan for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topic of relevance to this blog. Readers interested in publishing a guest post are encourage to contact me directly. Here is Dan's article: 

 

Cyber risks have become a major potential loss exposure for most corporations. Although nonexistent just a few years ago, most companies today are vulnerable to a growing list of threats relating to technology misuse. Not surprisingly, as businesses have become more reliant on technology, the resulting risks have become far more complex and potentially harmful.

 

Threats from hackers, thieves, third-party contractors, competitors and employees, as well as inadvertent misuse or loss of data, present potentially catastrophic financial and reputational risks to companies today. Even the most vigilant company can be a victim of a data breach or other cyber loss. Class action lawsuits, huge forensic and mitigation costs, notification and credit monitoring services and data restoration efforts can result in tens or even hundreds of millions of dollars of loss to a company. State attorneys general, federal and state regulators and plaintiff lawyers are all likely and formidable adversaries to the company if something goes wrong. In addition, the company’s computer systems may need to be shut down and business operations may be interrupted.

 

Like any other major risk exposure, directors should monitor the company’s cyber risks and confirm that reasonable steps are being taken to identify, prevent, mitigate and respond to cyber-related problems when they arise. Because these risks can damage not only the company but its customers, suppliers, other constituents and even the public, extra caution is necessary. Plus, new federal and state statutes and regulations are being adopted with increasing frequency which mandate appropriate company risk management practices in this area.

 

Directors are not expected to fully understand all of the risks, and all of the company’s risk management responses, in this highly technical area. However, directors should at a minimum comply with laws expressly applicable to them, should ask informed questions to gauge the company’s focus and preparedness in this area, and should generally understand the extent to which the company is insured—or not insured—for these exposures. The following discussion summarizes (i) new guidance from the SEC relating to cybersecurity risk disclosures, (ii) a sweeping new FTC rule relating to identity theft protection programs which requires board of director action, (iii) various questions a reasonably diligent director could ask to assure the company’s cyber risks are being properly addressed, and (iv) the types of insurance policies now available which cover—and do not cover—cyber risks.

 

A.      SEC Disclosure Guidance

On October 13, 2011, the SEC’s Division of Corporation Finance released “CF Disclosure Guidance: Topic No. 2 – Cybersecurity.” That “Guidance” summarizes the SEC’s views regarding a company’s disclosure obligations relating to cybersecurity risks and incidents. It does not change existing disclosure law, but merely explains the SEC’s interpretation of that existing law to the evolving topic of cybersecurity.

 

The Guidance defines “cybersecurity” as “the body of technologies, processes and practices designed to protect networks, systems, computers, programs and data from attack, damage or unauthorized access.” The Guidance recognizes that no existing disclosure requirement explicitly refers to cybersecurity risks and cyber incidents, but that “a number of disclosure requirements may impose an obligation on registrants to disclose such risks and incidents.” The Guidance also notes that material information regarding cybersecurity risks and cyber incidents “is required to be disclosed when necessary in order to make other required disclosures, in light of the circumstances under which they are made, not misleading.” The Guidance then highlights the following specific disclosure obligations that may require a discussion of cybersecurity risks and cyber incidents:

 

• Risk Factors.Consistent with the Regulation S-K Item 503(c), cybersecurity risk disclosures must adequately describe the nature of the material risks and specify how each risk affects the registrant. The Guidance specifically mentions that to the extent material, appropriate disclosures may include a description of relevant insurance coverage.

• MD&A. Registrants should address cybersecurity risks and cyber incidents in their MD&A if the costs or other consequences associated with one or more known incidents or the risk of potential incidents represent a material event, trend, or uncertainty that is reasonably likely to have a material effect. 

• Description of Business. If one or more cyber incidents materially affect a registrant’s products, services, relationships with customers or suppliers, or competitive conditions, the registrant should provide disclosure in this section.

• Legal Proceedings. If a material pending legal proceeding involves a cyber incident, the registrant may need to disclose information regarding such litigation in this section.

• Financial Statements. The Guidance reviews a number of situations in which cybersecurity risks and cyber incidents could impact a company’s financial statement disclosures, including disclosures regarding accounting treatment, depending on the nature and severity of the actual or potential incident.

• Disclosure Controls and Procedures. Registrants are required to disclose conclusions on the effectiveness of disclosure controls and procedures.

 

The Guidance is not a new disclosure rule and should not be viewed as creating additional disclosure obligations, or expanding a public company’s existing disclosure obligations, regarding cybersecurity. However, in any shareholder litigation arising from a cyber incident, plaintiffs will undoubtedly challenge the disclosures based on this new Guidance.

 

The intent and focus of these new Guidelines is to provide better clarity to public companies with respect to what disclosures are required by existing laws and regulations with respect to cyber risks and incidents. Obviously, the SEC wants shareholders to be informed about what harm has or could occur to the company with respect to cyber matters. In making those disclosures, the SEC recognizes that a company may need to disclosure what relevant insurance coverage the company maintains in order to put the risk disclosures into proper context (i.e. the existence and disclosure of insurance will tend to offset some of the potential harm to the company arising from the cyber risks being disclosed).

 

This new SEC Guidance, by itself, should not materially impact a company’s insurance purchasing decision.  Like other areas of risk management, the ultimate question is whether a company believes it is prudent to transfer some of its cyber risk via an insurance product.  That is a classic business decision that typically is protected from judicial second-guessing via the business judgment rule.  The SEC is not now suggesting that companies should or should not purchase cyber insurance, but is merely stating that in order to present a full picture of a company’s “net” cyber exposure, a description of any relevant insurance coverage may need to be included in the company’s cyber disclosures.

 

Companies are struggling with how to respond to this new SEC guidance since cyber risks and cyber incidents are so difficult to predict, evaluate, quantify and describe.  However, it is clear that there will be more cyber-related disclosures in the future than has occurred in the past.  Because of that, companies may want to mitigate shareholder concerns arising from those additional cyber disclosures by purchasing and disclosing the existence of cyber insurance.  Although disclosing insurance information in some contexts is not desirable because it may serve as a lightning rod for claims against the Insureds, that risk here should be minimal since most of the loss covered by a cyber policy would very likely be incurred with or without the policy existing and being known by third parties (i.e., the disclosure of a company’s cyber insurance should not attract claims that would not otherwise be filed as a result of a covered cyber incident).

 

B.                 FTC “Red Flags Rule”

Effective December 31, 2010, the so-called FTC “Red Flags Rule” (16 CFR 681) requires a wide variety of companies to adopt Identity Theft Protection Programs that identify warning signals which should alert a company to the risk of identity theft, and that detect, mitigate and deal with identity thefts when they occur. Importantly, the new Rule states that the Identity Theft Protection Program must be approved by the company’s board of directors or an appropriate committee designated by the board.

 

This new Rule applies to financial institutions and “creditors” with “covered accounts.” A “creditor” is broadly defined to mean “any person who regularly extends, renews or continues credit.” This definition appears to cover a wide variety of entities (including public utilities) that extend credit or give credit terms, such as permitting payment at the end of the month for goods or services rendered throughout the month. As a result, any company that permits deferred payments appears to be a “creditor” under this new FTC Rule. For example, if the company issues a bill and receives payment subsequent to the provision of the goods or services, that company probably is a “creditor” under this Rule. A “covered account” is likewise defined very broadly in the Rule to include an account offered primarily for personal, family or household purposes that involves or is designed to permit multiple payments or transactions. A “covered account” also includes any business account if identity theft with respect to that account presents a reasonably foreseeable risk to consumers or to the safety and soundness of the company.

 

Under the Rule, larger and higher-risk entities must have a more comprehensive Identity Theft Protection Program than smaller or lower-risk entities. These Programs must include the establishment, testing and deployment of an effective program to identify and act upon “red flags” which alert the company to identity theft or the potential for identity theft. Merely adopting a program without proactive enforcement and oversight does not satisfy the Rule. Directors should carefully review the Identity Theft Protection Program recommended by management and should, before approving that Program, assure themselves that the Program is reasonably robust, sufficiently tailored to the unique circumstances of the company, is properly funded and staffed, and will be periodically reviewed by senior management and the board for effectiveness.

 

C.                 Cyber Risk Questions for Directors

For many companies, cyber risks represent one of the most volatile and potentially damaging exposures to the company. However, because these risks are so new, evolving and complex, many boards have given little if any attention to these risks. Although each company faces unique cyber risks and therefore each company’s response to these risks should be unique, the following summarizes 10 important questions which directors could ask in order to better understand these risks and whether the company is adequately responding to these risks.

 

1. Is the responsibility and accountability for the creation, implementation, enforcement and updating of an integrated and company-wide cyber risk management program clearly defined at the executive level?
2. Does the management team which addresses cyber risks include senior representatives from executive management, IT, legal, risk management, public relations and compliance/audit?
3. Is the overall cyber risk management program periodically reviewed by the board?
4. Does a board committee have designated oversight responsibility for the cyber risk management program?
5. What are the company’s greatest cyber risks and how are those risks being anticipated, managed and mitigated?
6. Is each component of the cyber risk management program documented, frequently tested and periodically audited by independent experts, and what are the results of that testing and audit?
7. Are protocols for reacting to a cyber risk crisis when it occurs well defined and broadly understood?
8. Are all employees required to participate in regular education and training programs relating to cyber risks?
9. What is the company’s budget and staffing for cyber risk management and how does that compare with peer companies?
10. What, if any, insurance coverage does the company maintain for cyber risks and is that coverage adequate in scope and amount?

 

D.                 Insurance Coverage

Directors should understand the extent to which the company is insured or uninsured for potentially severe cyber-related losses. Like other large risk exposures, quality insurance coverage with adequate limits of liability can greatly mitigate the ultimate impact of a cyber loss to the company’s financial health. In addition, many companies contractually require their vendors to maintain network security insurance which covers the vendor’s liability to the contracting company for accidental or criminal losses caused by the vendor. As a result, a company’s cyber insurance coverage should reflect both the company’s risk management philosophies and contractual obligations.

 

Traditional insurance policies maintained by a company typically provide very little, if any, coverage for many types of cyber risk. Standard commercial general liability (“CGL”) policies usually only cover damage to “tangible property” and therefore would not respond to loss or injury to intangible property. Although some limited coverage may exist under these policies for “personal injury” or “advertising injury,” many recent CGL policies (including the newest standard ISO general liability policy form) specifically exclude various types of cyber risk.

 

Likewise, a company’s crime or fidelity policy may have limited applicability depending upon the nature of the cyber-related loss. But, if the cyber risk results in a claim against directors and officers, the company’s D&O insurance policy likely will respond because those policies generally afford “all risk” coverage, subject to several exclusions. The most likely exclusion in a standard D&O policy which potentially could apply to a cyber claim is the property damage exclusion. However, like the scope of coverage under the CGL policy, the scope of this exclusion in the D&O policy is usually limited to damage to “tangible” property, so the exclusion should be inapplicable to most cyber claims.

 

To address these likely gaps in insurance coverage for the company, many insurance companies now offer various types of insurance policies specifically designed to cover cyber risks. These policies frequently cover both third party claims against the insureds, and first party losses incurred by the insureds, relating to a wide variety of cyber risks. These policies vary greatly among insurers and are still evolving. Because the types of cyber risks are constantly changing and because the policy language in these new types of policies is still largely untested, the exact contours of these newer policies are still being refined.

 

The third party coverage contained within these cyber policies usually applies to defense costs, settlements, judgments and other loss incurred in claims against the insureds by customers or other third parties if the alleged loss results from a broad range of wrongdoing by the company in connection with computer system, internet or other information-related matters, including breach of privacy due to theft, loss or misuse of data (including credit card, financial or health-related data); conduct which causes network systems to be unavailable to third parties or susceptible to computer virus or other third party attacks; or libel, slander, defamation, plagiarism, copyright or trademark infringement or other injuries resulting from “media” activities.

 

Examples of first party coverages in cyber policies include business interruption coverage for loss of business income as a result of an attack on the company’s network; cyber extortion coverage; public relations coverage associated with restoring public confidence following a cyber incident; cyber terrorism coverage; identity theft coverage for misuse or loss of confidential or private information; data restoration coverage; and coverage for notifying affected parties, providing credit monitoring services, incurring forensic costs to determine how the breach occurred, and restoring damaged hardware or software.

 

Cyber risk policies can be tailored to fit the unique exposures and needs of a particular company. Once a company identifies its most troubling cyber risk exposures, the company should work with an experienced cyber insurance broker to define and negotiate the desired coverage features and the appropriate insurance markets for that coverage. Like other types of negotiable insurance products, knowing what to ask for is extremely important to getting what you need.

 

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Most states have adopted statutes providing individuals who serve as directors on nonprofit boards with limited immunity from liability. Among other issues that frequently arise is the scope of the protection provided under this statutory immunity. A recent decision from the Connecticut Appellate Court in a case involving a liability claim against the volunteer President of the nonprofit interpreted the statutory immunity expansively to encompass a broad range of activities. The decision provides interesting insight into the extent of immunity available to nonprofit board members. The Connecticut Appellate Court’s decision, released on January 1, 2013, can be found here.

 

Background

The Friends of Hammonasset is nonprofit volunteer organization organized under Section 501(c)(3) of the Internal Revenue Code. The organization works with the Hammonasset Beach State Park (a Connecticut State Park). Deanna Becker serves as the volunteer President of Friends. Becker is not compensated for her services.

 

In January 2010, the park held its annual “Owl Prowl” event. The Friends organization was invited to participate in the event and handled all of the publicity for it. One the evening of the event, one of the attendees slipped and fell on roadway and broke his wrist.

 

The injured individual filed a personal injury lawsuit against Friends and against Becker. The trial court entered summary judgment for both defendants, holding that the plaintiff had not alleged sufficient facts to support a claim for premises liability against Friends and also that Becker has immunity from plaintiff’s claims brought against her in her capacity as President of Friends. The plaintiff appealed.

 

The Appellate Court’s decision

On appeal the plaintiff argued that the trial court erred in entering summary judgment in Becker’s favor because his claims against Becker did not relate to duties or activities within the scope of the statutory immunity.

 

The statutory immunity provisions, which are contained in Connecticut General Statutes Section 52-557m, provide that the officer or director of tax-exempt organization who is “not compensated” for their services “shall be immune from civil liability for damage or injury … resulting from any act, error or omission made in the exercise of such person’s policy or decision-making responsibilities if such person was acting in good faith and within the scope of such person’s official function and duties, unless such damage or injury was caused by the reckless, willful or wanton misconduct of such person.”

 

In his appeal, the plaintiff argued that this section does not apply because he did not allege that Becker was negligent in her “policy or decision-making responsibilities.” Rather, he alleged that she was negligent in her supervising, training and oversight activities as the President of Friends, in that she allegedly failed to suet up a walk through of the path to determine if safety hazards existed; failed to assign a member of Friends to do a walk through; and failed to notify or assign a volunteer to notify the state to plow or sand the area.

 

The Appellate Court determined that these alleged activities of Becker were within her “policy or decision-making responsibilities,” noting that:

 

When the phrase “decision-making responsibility” is examined in conjunction with the dictionary definitions of supervise, oversee and train, the allegations in the complaint describe conduct falling squarely within Becker’s decision-making responsibilities. The allegations imply that Becker had the authority to make decisions that included ordering a walk through of the park before the event, directing that a Friends volunteer perform the walk through, and informing the state of dangerous conditions that the volunteer might find. Accordingly, the plaintiff cannot prevail on his claim that decision-making responsibilities do not encompass supervising, training and overseeing.

 

The Appellate Court also rejected the plaintiff’s contention that the state statutory immunity provision was preempted by the federal Volunteer Protection Act. The Act contains a provision preempting any state law to the extent that it is inconsistent with the Act, but exempting from preemption any state statue that provides “additional protection” to volunteers. The Appellate Court interpreted the Connecticut statutory provisions to provide “greater protections” than the Act, and accordingly the Appellate Court concluded that the Act did not preempt the Connecticut statutory provisions.

 

Discussion

In a January 21, 2013 Hartford Business Journal article discussing this decision (here), Dylan Kletter, an attorney with the Brown Rudnick law firm, notes that the Appellate Court’s decision confirms that the statutory immunity provisions “provide broad protection” for volunteer nonprofit board members and officers, adding that

 

Although the scope of an officer or directors’ “policy or decision-making responsibilities” will vary based on the unique facts of each tax-exempt organization’s mission and activities, the court’s decision gives comfort to such volunteer officers and directors and reinforces the concept that unless such an individual acts with “reckless, willful or wanton misconduct” in the exercise of their duties, they may similarly qualify for total immunity from legal liability and damages.

 

Most other states statutory immunity provisions are similar to those of Connecticut, so the “comfort” that volunteer directors and officers can take from this decision is not limited just to those in Connecticut. The decision provides reassurance that courts will broadly interpret the scope of responsibilities for which the immunity protection is available. (It should be noted that some statues require that the nonprofit organization’s by-laws must expressly grant the immunity in order for an individual to be entitled to the immunity.)

 

But though this decision is reassuring for volunteer directors and officers, it nevertheless must be kept in mind that the immunity available under these statutory provisions is limited – and limited in a number of ways.

 

First, the protection is only available to nonprofit directors and officers who are not compensated. So if for example a nonprofit organization were to bring on their board a specialist of some kind who provides the organization with some indispensable exercise and if that individual were compensated for their board service, that individual likely would not qualify for the statutory immunity. 

 

Second, the scope of the statutory protection is limited. It not only is restricted to “policy and decision-making responsibilities” but only to those within “the scope of such person’s official function and duties.” At a minimum, these limitations present potentially fruitful grounds for dispute over the questions whether the individual’s alleged misconduct was with the scope of protected activities, as this case shows.

 

Third, the statutory provisions restrict not only the breadth of activities that are protected but also the kind of activities that are protected. Thus the immunity is not available when the individual officer or director was not “acting in good faith” or was engaging in “reckless, willful or wanton misconduct.” Plaintiff’s lawyers interested in averting the statutory immunity defense will likely keep these limitations in mind when drafting the complaint and will shape their allegations accordingly.

 

Finally, although it is kind of obvious, it is worth noting that even at its greatest extent, the statutory immunity provisions protects only individuals. It does not protect the nonprofit organization itself.

 

The volunteer directors and officers of nonprofit organizations can be reassured that they have immunity from liability for claims of negligence against them in connection with their actions undertaken within the scope of their duties. But because there are numerous limitations to the protection availably under the immunity statutes, it remains important for these organizations and their representatives to ensure that the organizations have and maintain a comprehensive program of liability insurance, including in particular broad, state-of-the- market D&O insurance. Because of the extent of the scope of protection afforded under these insurance programs is so important for nonprofit organization directors and officers, they will want to ensure that a knowledgeable and experienced insurance professional designed and placed their program.

 

The FDIC Ramps Up the Lawsuits: Earlier last week, I noted that the FDIC had filed the first of failed bank D&O lawsuit in 2013. I speculated at the time that there would be many more cases to come this year. As if to prove my point, late last week, the FDIC filed two more failed bank lawsuits, including the latest the agency has filed involving a failed Georgia bank. Both of the new lawsuits were filed on January 25, 2013. Both of the banks involved failed on January 29, 2010, so that agency filed its lawsuits just before the third anniversary of the banks’ failures and just ahead of the end of the statute of limitations period.

 

First, the agency filed an action in the Western District of Washington in its capacity as receiver for the failed American Marine Bank of Bainbridge Island, Washington against four officer defendants (one of whom was also a director) and six director defendants. The FDIC’s complaint (a copy of which can be found here) alleges claims for breach of fiduciary duty, gross negligence and negligence. Among other things, the FDIC alleges that the defendants “took unreasonable risks with the Bank’s loan portfolio; allowed irresponsible and unattainable rapid asset growth concentrated in high-risk and speculative” construction and commercial real estate loans; and “disregarded regulator advice and criticisms regarding lending activities. The complaint alleges that the defendants’ actions caused damages to the bank of “no less than $18 million.”

 

Second, in the latest lawsuit the agency has filed involving a failed Georgia bank, the FDIC filed an action in the Northern District of Georgia against eleven former directors and officers of the failed First National Bank of Georgia, of Carrollton, Georgia. In its complaint, which the FDIC filed in its capacity as receiver for the failed bank, the FDIC asserts claims for negligence, gross negligence and for breach of fiduciary duties. The complaint, which can be found here, alleges that the defendants failed to properly oversee the bank’s lending function, improperly approved millions of dollars in loans, allowed excessive concentration in certain lending areas and knowingly permitted poor loan underwriting. The FDIC alleges that these actions cause damages to the bank in excess of $29.97 million.

 

These latest lawsuit are the 46^th and 47^th that the agency has filed as part of the current failed bank wave and the second and third so far in 2013. For whatever reason, the FDIC’s suits have been disproportionately concentrated in Georgia. This latest suit is the 15^th in Georgia so far, meaning that just under third of all of the FDIC’s lawsuits have involved failed Georgia banks. Though more banks have failed in Georgia than any other state as part of the current bank failure wave, Georgia’s bank failures represent far less than a third of all bank failures. There may be some timing issues here as many Georgia banks were among the first to fail but it still remarkable how many suits the agency has filed in the state.

 

Scott Trubey’s January 25, 2013 Atlanta Journal Constitution article about the latest Georgia lawsuit can be found here. Special thanks to a loyal reader for sending me a link to the article and alerting me to the new lawsuit. Special thanks to yet another reader for sending me a copy of the Western District of Washington complaint.

 

Advisen Claims Trend Seminar: On Tuesday January 29, 2013 at 11 am EST, I will be participating in a Quarterly D&O Claims Update Webinar hosted by Advisen. The webinar will provide a quarterly review of securities and other litigation impacting D&O coverage and will identify and analyze the trends of greatest significance to Risk Managers and Management Liability professionals. The participants in this free webinar will include AIG’s Tom McCormack, and Advisen’s David Bradford and Jim Blinn. Further information about the seminar, including registration instructions, can be found here.

 

A Spectacle Too Many Are Missing: One of the world’s great sporting events is taking place, yet very few are paying any attention. The 2013 African Cup of Nations soccer tournament is being played now (actually, between January 19, 2013 and February 10, 2013) in South Africa. Though the tournament features many of the world’s best soccer players as well as a host of upstarts, the tournament undeservedly is receiving little attention, particularly in the United States.

 

Among the many incredibly talented players participating are the tournament are reigning African Footballer of the Year, Yaya Touré of the Côte d’Ivoire (who plays his club football for Manchester City in the English Premiere Leagu); Emmanuel Adebayor, the Togolese football player and striker for Tottenham Hotspur in the English Premier league; Michael Essien, the Ghanian player who is currently playing for Real Madrid in La Liga, the Spanish football league, on a season loan from Chelsea in the English league; and Gervinho, who plays for Côte d’Ivoire and for Arsenal in the English Premier League. There are many others great players as well.

 

Even more exciting than these marquee players are the upstarts, like the team from Niger that has qualified for the tournament for only the second time, or the team from tiny Cape Verde Islands, which has never previously qualified for the tournament, yet, after a stunning 2-1 victory on Sunday against Angola, is sitting in second place in its tournament bracket and has already qualified for the tournament’s next round.

 

The tournament has featured some brilliant games, including in particular the game in which Burkina Faso, which had hung on throughout the game, scored in the fourth minute on stoppage time on the absolute final play of the game to pull off a tie against a much more talented Nigerian team, or the game in which an inexperienced Niger side played with sheer determination to scrap out a nil-nil draw against the much more experienced team from the Democratic Republic of Congo.

 

A soccer aficionado friend of mine regards the world’s seeming inattention to these games with a shrug, noting that it may be that international soccer competitions, like Opera or Single-Malt Scotches, are an acquired taste that can be appreciated only by the cognoscenti. I disagree. This tournament features the highest level of athleticism and games that flow with an incredible beauty. I think many sports fans would be drawn into these games on first glimpse of they only saw the games.

 

The games are actually a lot easier to see this year than during prior tournaments, because ESPN 3 is showing at least some of the games live – but because of the time difference, they are being broadcast during the morning in the U.S., which is not a time when most people are watching sports. For those who are interested in the games or who think they might be interested, but aren’t interested in sitting down to watch soccer at 10 am in the morning, the best way to watch these games is through the Watch ESPN app. On the ESPN 3 Channel on the App, under the Replay tab, all of the games are listed by date. (You can also find all of the games by clicking on the Sports tab along the top of the user interface and clicking on “Soccer” in the drop down menu).

 

To get a sense of the sheer athleticism this tournament involves, as well as the incredible enthusiasm of the teams’ supporters, watch this video of the 22 year-old Tunisian forward, Yousef Msakni, scoring the game winning goal in stoppage time in a first-round game against Algeria:

 

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In addition to indemnification, corporate directors and officers also may have the right under applicable law and corporate by-laws to have their costs of defense advanced before the ultimate right to indemnification has been determined. A question that often arises is whether a corporation may withhold advancement. A recent decision from the Ontario Superior Court of Justice determined that a corporation did not have to advance the costs certain former directors and officers had incurred in defending claims the corporation had filed against them. The decision is clearly significant for directors and officers of companies in Canada, but it also provides an interesting context within which to consider the limits of advancement rights here in the U.S. as well. A copy of the September 28, 2012 decision can be found here.

 

Background

Look Communications is a technology company organized under the Canadian Business Corporations Act (CBCA). Its business fortunes faltered and its board ultimately approved a sale of its assets through a court-supervised process. Following the sale, the board authorized the payment of bonuses to certain officers and directors and also allowed corporate officials to receive compensation for the cancellation of certain stock option and other equity rights. Altogether the company paid over $20 million in bonus compensation and in compensation for the options and equity rights, representing about 32% of the asset sale proceeds.

 

After the award of the bonuses and other compensation was disclosed, shareholders filed significant objections. The board authorized the payment of $1.5 million in retainers to law firms acting on behalf of the directors and officers, who then resigned once the retainers had been paid.

 

In July 2011, after an investigation by Look’s new management, Look commenced an action against the former directors and officers alleging that the individuals had breached their fiduciary duties and seeking repayment of the bonuses and equity cancellation payments. The individual defendants, in reliance on the company’s by-laws as well as a written indemnification agreement, demanded that the company advance their expenses incurred in defending against the company’s lawsuit. The company refused and the individuals filed separate actions seeking judicial declarations of their advancement and indemnification rights.

 

Under Section 124 of the CBCA, a company may indemnify its directors and officers for legal proceedings in which the individuals become involved as a result of their association with the company, as long as the individual seeking indemnification “acted in good faith and with a view of the best interests of the corporation.” Look’s by-laws made these permissive indemnification rights mandatory. A separate indemnification agreement required Look to advance legal costs in any proceeding, including one brought by Luck itself, subject only to an obligation to repay if a court determined that the individual was not entitled to indemnification.

 

The former directors and officers argued in reliance on the by-laws and indemnification agreement that they were entitled to automatic advancement of their defense fees; that they were also entitled to a presumption that they had acted in good faith; and that their ultimate entitlement to indemnification could only be determined after a full evidentiary trial.

 

Look argued in reliance on Section 124(4) that a corporation is permitted to advance defense fees only “with the approval of the court,” which, Look argued, required the court to assess the parties’ conduct to determine whether the persons seeking advancement had acted in good faith. Look further argued that the individuals had not acted in good faith and were not entitled to advancement and submitted affidavits and other materials in support of this position.

 

The Court’s Ruling

In his September 28, 2012 opinion, Justice Laurence A. Pattillo noted the court’s critical supervisory role in the statutory indemnification scheme, observing that “in my view, requiring the court to scrutinize indemnification and advances in circumstances where a corporation has sued its former directors and officers ensures corporations cannot arbitrarily avoid indemnity and advancement obligations to former directors and officers who have acted in good faith and in the best interests of the corporation, while at the same time ensuring that directors and officers who have not so acted cannot further harm the corporation.”

 

Justice Pattillo further observed that the court’s supervisory role still obtained notwithstanding the fact that the parties had a written indemnification agreement that made the rights to advancement automatic. He said that just as a corporation cannot indemnify a director or officer if the statutory requirement of good faith conduct has not been met, “neither ... can they contract to exclude the court’s discretion to approve advancement.”

 

Justice Pattillo further concluded that the court approval specified under Section 124(4) requires the consideration of evidence. Because the directors and officers are entitled to a presumption that they acted in good faith, the burden is on the corporation seeking to avoid advancement to establish a “strong prima facie case” that the statutory standard has been met.

 

Based on the affidavits and other material Look submitted, Judge Pattillo concluded that Look had presented sufficient evidence that all but one of the individuals seeking advancement had acted in bad faith, in their own self interest and not in the best interest of the company, and therefore were not entitled to advancement.

 

Discussion

This case represents an unusual circumstance where a corporation was able to avoid its obligation to advance defense expenses of its directors and officers. It is, however, a reflection of both the unusual factual circumstances and the particular features of the applicable Canadian statutory provisions. The indemnification provisions in the Delaware Corporations Code (which governs the many U.S. corporations incorporated in Delaware) do not contemplate the same level of judicial supervision that the court exercised here. Indeed, Justice Pattillo specifically declined to consider Delaware case law, notwithstanding the fact that Delaware courts are “well regarded in this area of the law,” noting that the Delaware statutory provisions “contain no statutorily imposed conduct requirement.”

 

The outcome is also a reflection of the unusual facts involved. As the Osler law firm noted in its October 11, 2012 memorandum about the decision (here), the facts in this case (at least as found on an interim basis) “appear to have been exceptional” and that in many other cases, courts would be unable to make the kind of determination made here solely on the basis of a “paper record,” without live witnesses and credibility determinations.

 

While the outcome here may be the result of the uncommon factors, what is not uncommon is for these types of advancement disputes to arise, particularly where, as here, the claims have been brought against former management by their successors and the claims is asserted on behalf of the corporation. The successor management often contends that the corporation should not have to fund the defenses of the persons whose conduct they are claiming to have harmed the corporation.

 

As I noted in a recent post discussing an advancement decision under Ohio law (here), the general pattern and practice is that corporate directors and officers are entitled to have their defense fees advanced, subject only to an undertaking to repay in the event of an ultimate determination that the individual is not entitled to indemnification.

 

The Ontario court’s decision is noteworthy not only because of the critical supervisory role the court played in the determination of the individual’s advancement rights, but also because of the court’s determination that it was obligated under the statute to play the supervisory role notwithstanding the parties’ agreement to make the right of advancement automatic.

 

For corporations frustrated by their advancement obligations, the level of court supervision exercised here may represent an attractive model. I will say though that there is also something to be said for the rights of corporations and their directors and officers to arrange their indemnification and advancement obligations contractually, at a time when there are no claims pending, and for those arrangements to be respected when the claims do arise. I also note a concern about substantive legal rights being decided on less than a full evidentiary record. Here, because these individual defendants will now not have their defense fees advanced, they may be forced to settle simply to avoid financial ruin, whether or not that outcome is actually warranted by the merits of the dispute.

 

The Story of the Year?: Two recent guest posts on this site have discussed the question of fiduciary liability insurance coverage for settler liability claims. First, on September 19, 2012, Kim Melvin and John Howell of the Wiley Rein law firm posted a guest post (here) commenting on the New York Court of Appeals decision in Federal Ins. Co. v. IBM (2012), which was followed by an October 11, 2012 commentary by Rhonda Prussack and Larry Fine of AIG (here).

 

Now in a October 15, 2012 post on his blog, The D&O E&O Monitor (here) , Joe Monteleone has added his observations about the exchange of views in the two guest posts on this site. Among other things, Joe refers to the questions that the New York case has raised as “the story of the year.” Joe provides some interesting additional insight on the issues as well.

 

Homeowners File Latest Libor-Related Antitrust Case: On October 4, 2012, a group of homeowners filed the latest class action lawsuit against the banks that participated in setting the Libor rates. In their complaint, which can be found here, the homeowners, who had adjustable rate mortgages tied to the Libor benchmark, allege that they were harmed by the rate-setting banks’ alleged manipulation of the rates. The homeowners assert claims based on the Sherman Act, the New York antitrust laws and RICO. Although there have been numerous antitrust actions previously filed against the Libor rate setting banks, this lawsuit, according to press reports, is the first to be filed on behalf of homeowners.

 

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As the various forms of social media have become increasingly pervasive, employers have struggled with appropriate responses to employees’ use of the social media sites. One question in particular that has arisen is the extent to which employers can seek to regulate and even discipline employees’ use of social media to comment on the employer or their workplace. A recent decision by a three-judge panel of the National Relations Board, addressing the social media policies of Costco Wholesale Corp. held that the company’s social media policy violated its employees’ rights under the National Labor Relations Act. A copy of the NLRB’s September 7, 2012 Decision and Order can be found here.

 

I should note at the outset that this NLRB ruling was discussed by a panel at the Advisen Management Liability Insights Conference in New York last Thursday. In addition, a work colleague also forwarded me a copy of the Blank Rome law firm’s September 2012 memo about the NRLB’s ruling. I acknowledge here my indebtedness to the conference panel and to my work colleague for identifying this topic and suggesting many of the comments in this post.

 

The NLRB’s Costco ruling arose out of efforts at the company’s Milford, Connecticut facilities to organize the facilities’ meat department employees. In connection with these activities, the concerned union filed charges with NLRB alleging that the company had violated the employees’ rights under the National Labor Relations Act. Among other things, the Union alleged that the company had certain unlawful rules in its employee handbook. Among these rules is one stating that “any communication transmitted, stored or displayed electronically must comply with the policies outlined in the Costco Employment Agreement.”

 

The rule goes on to state that statements “posted electronically (such as [to] online message boards or discussion groups) that damage the Company, defame any individual or damage any person’s reputation, or violate the policies outlined in the Costco Employee Agreement may be subject to discipline, up to and including termination of employment.”

 

The Administrative Law Judge who heard the union’s charges upheld this rule, determining that employees would reasonably conclude that the company’s purpose in devising h the rule was to ensure a “civil and decent workplace.”

 

The NLRB rejected the ALJ’s determination, concluding to the contrary that the rule “allows employees to reasonably assume that it pertains to – among other things—certain protected concerted activities, such as communications that are critical to the Respondent’s treatment of its employees.” The Rule, the NLRB said, “clearly encompasses concerted communications protesting [Costco’s] treatment of its employees.” Costco’s maintenance of the rule therefore “has a reasonable tendency to inhibit employees’ protected activity” and as such “violates” the National Labor Relations Act.”

 

The Blank Rome law firm’s memo comments that the NLRB’s ruling, (the NLRB’s first binding decision on the issue) “serves as a reminder to employers to review the scope of their social media policies and to carefully analyze how they may be construed.”

 

As noted in a September 21, 2012 memorandum from the Franczek Radelet law firm about the ruling (here), the need to review social media policies applies to both union and non-union employers, adding that “now more than ever, all employers should continue to review and update all of their policies to ensure that they are specific, narrowly tailored to their business needs, and do not sweep so broadly so as to interfere with employee rights under federal labor law.”

 

In thinking about the potential EPL insurance implications of this development, it is important to note that many EPL policies have National Labor Relations Act exclusions, precluding coverage for claims based upon alleged violations of the NLRA or similar federal, state and local statutes. However, many insurers are willing upon request to amend this exclusion to provide a carve-back specifying that the NLRA exclusion does not apply to claims for retaliation.

 

A retaliation carve-back to the EPL policy’s NLRA exclusion would not preserve coverage for all claims asserting that a company’s social media policy violates the NLRA. However, Costco’s social media policy not only contemplated discipline for violation of the policy, but expressly allowed for employee termination. The retaliation claim coverage carve-back to the NLRA exclusion might preserve coverage for a claim by an employee that he or she was terminated in retaliation for engaging in activity that contravened a social media policy that violated the NLRA – or to put it more simply, in retaliation for engaging in activity protected by the NLRA. However, even among carriers who are willing to extend the carve-back to the NLRA exclusion, the carriers sometimes restrict the carve-back so that it does not extend to extend coverage to class or mass action claims.

 

Jay Rockefeller’s Cyber Security Letter: On September 19, 2012, John D. Rockefeller, IV, the Democratic Senator from West Virginia, sent a letter to the CEOs of all of the Fortune 500 companies, asking each CEO to voluntarily respond by October 19, 2012 to several broad questions pertaining to the company's view on cybersecurity and to the federal government's efforts to promulgate national cybersecurity standards. A copy of hte letter Senator Rockefeller sent to IBM's CEO can be found here. ,  

 

As detailed in a September 19, 2012 memorandum from the Gibson Dunn law firm (here), Rockefeller’s letter follows his unsuccessful efforts earlier this year to pass legislation intended to impose heightened cybersecurity standards on a national level. (Indeed, a cynical reader might say that the letter is basically just one long gripe to the CEOs that the legislation failed to pass due to a filibuster and the efforts of business lobbyists.)   The law firm memo also points out that the letter follows other efforts Rockefeller has made to focus on cybersecurity outside of the legislative process, including his successful efforts last year to have the SEC provide guidance to pubic companies on what disclosures they should make concerning the companies’ cybersecurity risks and incidents.

 

The letters in and of themselves are unlikely to change anything. However, Rockefeller’s continuing efforts underscore the fact that cybersecuity is likely to remain both a high profile issue and a highly politicized issue. At the same time, other companies will find themselves, as Google recently did, under increased pressure to make disclosures regarding cybersecurity risks and incidents.

 

With increasing public scrutiny on companies’ cybersecurity preparedness and disclosure comes the increasing likelihood comes the increasing possibility that companies experiencing cybersecurity incidents —and their directors and officers -- may face claims from shareholders and other constituencies that they failed to implement appropriate cybersecurity measures or made misrepresentations about their cybersecurity preparedness. As recently noted in Rick Bortnick’s Guest Post on this blog, potential D&O liability is one of the significant components of cyber risk. The high-profile nature of these issues and the level of scrutiny increase the likelihood that we will see claims against companies’ directors and officers based on cybersecurity preparedness and cyber disclosure.

 

Concerns About JOBS Act Fundraising:  Another topic that the Advisen conference in New York addressed last week was whole topic of concerns with fundraising activities enabled by the recently enacted JOBS Act. The Act’s provisions permitting crowdfunding and loosening restrictions on solicitation and advertising for exempted offerings at a minimum create a context within which liability claims could arise and also increase the possibility for fraud. The Act’s provision raising from 500 to 2,000 the number of shareholders a company may have before it takes on SEC reporting obligations not only increases the potential scale of these problems but also ramps up the number of prospective claimants that might object.

 

As the panel at the Advisen conference discussed, these concerns will pose a host of challenges not only for prospective investors but for private company D&O underwriters, as well. A September 22, 2012 Wall Street Journal article entitled “On Crowdfunding and Other Threats” (here) reviews the steps that prospective investors can take to try to avoid getting scammed in a JOBS Act offering. Though the list of steps in the article are addressed to the investors hoping to avoid getting defrauded, the list also provides a useful starting point for D&O underwriters trying to think about and to  underwrite these risks. At a minimum, it seems clear that caution is indicated here, both for investors and for insurance underwriters

.

Readers interested in a more positive perspective on the possibilities of new forms of funding such as “crowdfunding” may want to take a look at the article in this week’s issue of Time Magazine entitled “The Kickstarter Economy” (here, subscription required). The article chronicles the successes of (and challenges for) the Kickstarter, the online fundraising portal. The article optimistically suggests that the online fundraising will support nascent enterprises that are well-intentioned and worthy. At the same time, the article also documents many initiatives that failed to live up to their own aspirations.

 

One of the panelists at the JOBS Act session at last week’s Advisen conference was Carl Metzger of the Goodwin Proctor firm, who pointed out that his firm has a page on its website devoted to JOBS Act- related concerns. The firm’s webpage, which can be found here, is a good one-stop resource on JOBS Act issues and developments.

 

German Court Dismisses Investors’ Porsche Suit: As I have discussed in numerous posts on this blog (most recently here),  aggrieved investors who lost money short-selling VW shares and who claim they were misled by Porsche’s management have been trying to pursue claims against Porsche and its senior officials in U.S. courts. (Background regarding the dispute can be found here.) After their initial U.S. federal court action was dismissed (about which refer here), some investors tried to pursue claims against Porches in Germany’s courts. Now, according to press reports (refer here), the first two of these German lawsuits to be considered have been dismissed.

 

According to the news reports, the Braunschweig regional court determined that the allegedly misleading statements on which the investor claimants sought to rely in support of their claims against Porsche did not amount to “vicious behavior” that would have misled investors A statement on the court’s website about the September 19, 2012 court determination (in German) can be found here. According to the news reports, three additional cases remain pending before the same German court.

 

The outcome of the two German cases highlights why the aggrieved investors tried first to assert their claims in the U.S., and why some investors are continuing to press the U.S. claims. The appeal of the dismissal of the original U.S. federal court lawsuit remains pending in the Second Circuit. In addition, other investors’ New York state court common law claims have survived an initial motion to dismiss (about which refer here). This long-running litigation saga continues to grind on, but the outcome of the two recent German court decisions seems to suggest that whether investors are to have any hope of relief will depend on further developments in the U.S. proceedings, particularly the pending appeal in the Second Circuit.

 

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Under the Responsible Corporate Officer Doctrine, corporate officials can be held liable for misconduct in which they did not participate and of which they have been entirely unaware, based on their responsibility for the corporation itself. As shown in a July 27, 2012 opinion from the District of Columbia Court of Appeals (here), a misdemeanor conviction based on the Responsible Corporate Officer doctrine can not only result in criminal penalties  but can also include  “career-ending” consequences, in the form of a lengthy ban from participating in governmental programs. Although the appellate court struck down the specific disbarment at issue in the case, it upheld the government’s right to impose the ban.

 

As discussed below, this case serves as a reminder of the significant exposures corporate executives face under the Responsible Corporate Officer Doctrine.

 

Background

Purdue Frederick Company was accused of fraudulent misbranding of the painkiller OxyContin. Among other things prosecutors alleged that unnamed employees of the company marketed OxyContin as less addictive and less harmful than other painkillers. The company ultimately pled guilty to felony misbranding. Among other things, monetary sanctions of about $600 million were imposed on the company.

 

Under the Responsible Corporate Officer Doctrine, three Purdue executives – Purdue CEO Michael Friedman, general counsel Howard Udell, and medical director Paul Goldenheim—were accused of the misdemeanor of misbranding of a drug. The individuals pleaded guilty to misdemeanor misbranding, for (as the appellate court put it) “their admitted failure to prevent Purdue’s fraudulent marketing of OxyContin.” The individuals were sentenced to extensive community service, fined $5,000, and ordered to disgorge compensation totaling about $34.5 million.

 

Several months after the individuals’ conviction, the Department of Health and Human Services determined that the individuals should be excluded from participating in Federal health care programs for 20 years. During the individuals’ ensuing administrative appeals, the individuals managed to get the length of the disbarment reduced to 12 years. The 12 year disbarment ultimately was affirmed by a U.S. District Court, and the individuals appealed, arguing that the agency did not have the authority to impose the disbarment and also arguing that because the agency lacked a substantial basis for the length of the disbarment, its imposition was arbitrary and capricious and therefore invalid.

 

The July 27 Opinion

In a July 27, 2012 opinion written for a divided three-judge panel, D.C. Circuit Administrative Judge Douglas Ginsberg affirmed the agency’s authority to impose the disbarment, but agreed with the individuals that in this case the imposition of the 12-year disbarment “was arbitrary and capricious for want of a reasoned explanation for the length of their exclusions,” and the court remanded the case to the District Court for further proceedings. Chief Judge David Sentelle concurred in part and dissented in part, noting that he would have affirmed the length of the disbarment.

 

None of the three judges questioned the agency’s authority to impose disbarment. Judge Ginsberg’s opinion expressly rejected the individuals’ argument that the agency’s imposition of the disbarment for an offense lacking a mens rea element (that is, lacking a culpable state of mind) violated their constitutional rights to due process. Among other things, the individuals noted that the imposition of criminal penalties under the Responsible Corporate Officer Doctrine had been upheld in the past only because the “associated penalties commonly are relatively small, and conviction does no grave damage to an offender’s reputation.”

 

The appellate court rejected this constitutional argument, saying that “we do not think excluding an individual … on the basis of his conviction for a strict liability offense raises any significant concern with due process,” adding that “surely the Government constitutionally may refuse to deal further with senior corporate officers who could have but failed to prevent a fraud against the Government on their watch.”

 

The court did hold that the agency had failed to justify its imposition of a 12-year disbarment, noted that “we do not suggest that the appellants’ exclusion for 12 years based upon a conviction for misdemeanor misbranding might not be justifiable; we express no opinion on that question. Our concern here is that the [agency’s administrative review board] did not justify it in the decision under review.” Noting that no prior disbarment had exceeded ten years, the court concluded that the agency’s decision was “arbitrary and capricious with respect to the length of their exclusion because it failed to explain its departure from the agency’s own precedents.”

 

Discussion

If nothing else, this case serves as a reminder of the power that the Responsible Corporate Officer Doctrine gives prosecutors to pursue criminal charges against corporate officials based on the misconduct of the officials’ subordinates in which the officials were not involved and of which the officials may have been entirely unaware. And even though the appellate court reversed the “career ending” disbarment that the agency had imposed on the corporate officials here, the appellate court emphasized that there was nothing inherently wrong with the length of the disbarment; the appellate court’s reversal was strictly based on the agency’s failure to explain the length of the disbarment.

 

Indeed, the appellate court expressly affirmed the agency’s authority to impose disbarment even in the case of strict liability offense that lacked any culpable state of mind. The court seemed entirely untroubled by concerns surrounding convictions under the Responsible Corporate Officer doctrine that these convictions involve the imposition of liability without culpability in the form of a guilty state of mind. (For more about concerns with imposing liability about culpability, refer to my prior post here).

 

To be sure, in connection with their pleas of guilty to misdemeanor misbranding, the individuals had expressly admitted that they had “responsibility and authority either to prevent in the first instance or to promptly correct” the misbranding activity. Their convictions and their admissions, as well as the seriousness of the underlying misconduct, may cast this case in a different light.

 

Nevertheless, I continue to find the willingness of courts and regulatory authorities to impose criminal convictions and “career restricting” penalties on officials who had no involvement in or even awareness of the misconduct to be troubling. The court itself noted that the justification for the strict liability imposition of criminal liability based on the Responsible Corporate Officer Doctrine was premised in part on the supposition that that the penalties involved were relatively small. There is nothing small about the type of career-ending disbarment the government sought to impose here. To the contrary, this case shows that the consequences for individuals convicted under the responsible corporate officer doctrine can be significant.

 

A July 2012 memo from Eric Reed of the Fox Rothschild law firm entitled “Even Without Knowledge or Participation, Corporate Officers Can Be Criminally Liable for Subordinates’ Misdeeds” (here) points out that this case “stands as a reminder” of several concerns about the Responsible Officer Doctrine, including that “ignorance of misconduct by subordinates is not always a defense for corporate officers.” This case also shows that “when violations occur, resolving regulatory or criminal charges may not conclude all liabilities for a particular occurrence” and in parallel administrative or agency proceedings “facts admitted or proved in an initial proceeding may bind in the later matters.”

 

One of the bedrock principles of our criminal justice system is that a prerequisite of liability should be a finding of culpability. Even if, as courts now seem comfortable in assuming, there are circumstances where the kind of strict liability imposed under the Responsible Corporate Officer Doctrine is appropriate, that type of liability should be rare and imposed sparingly. My concern, as I have noted elsewhere, is that the imposition of this type of liability is becoming increasingly common and is imposed far too often. As this case shows, the consequences for individuals on whom this type of liability is imposed can not only be substantial, but it can be career-ending. This deeply troublesome trend deserves far greater attention, and the constitutional concerns raised here deserve much closer consideration than they were given by this court.

 

Susan Beck’s July 30, 2012 article on the Am Law Litigation Daily about the D.C. Circuit’s opinion can be found here.

 

Goldman Sachs Settles Mortgage-Pass Through Securities Suit: The parties to the Goldman Sachs/ GS Mortgage Pass Through Certificates securities suit have reached an agreement to settle the case for $26.6125 million. The settlement is subject to court approval. In addition, as reflected on the parties’ July 31, 2012 motion for preliminary court approval of the settlement (here), the settlement is subject to a $1.3125 reduction if Stichting APB (which filed a separate action relating to the mortgage-pass through certificates) elects not to participate in the class settlement. The settlement fund is inclusive of $5.3 million for attorneys’ fees and expenses. The parties’ stipulation of settlement can be found here.

 

As noted in detail here, the case had in January 2011 survived in principal part the defendants’ motion to dismiss. The court had subsequently certified a plaintiff class. The defendants had sought leave to appeal the class certification to the Second Circuit. The defendants’ petition to the Second Circuit, which remained pending at the time the settlement was reached, has now been stayed pending approval of the settlement.

 

Alison Frankel has an interesting August 1, 2012 post on her On The Case blog about the GS Mortgage Pass-Through Certificates Settlement, in which she asks, among other things, whether the MBS cases are turning out to be a "bust" for the plaintiffs' lawyers. As always, Frankel has interesting thoughts and observations on the topic. Her post can be found here. I should add that if your not reading all of Alison's posts every single day,  you are making a very serious mistake.

 

I have in any event added the Goldman mortgage pass-through certificate settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here.

 

Corrected Link: Yesterday, I wrote about the latest antitrust lawsuit to be filed in the wake of the emerging Libor scandal. Unfortunately, it appears that the link I originally put up on the site to the new case complaint was faulty. I have corrected the link. Readers who may have wanted to see the complaint but were unable to do so owing to the faulty link can see the complaint here. I apologize for the faulty link as well as any confusion the faulty link may have caused.

 

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One of the most important sources of director protection is corporate  indemnification. But as significant as indemnification is for the protection of directors, the directors’ first line of defense, literally, is their right to advancement of their costs of defense. All too often, these two terms – advancement and indemnification – are used interchangeably, but they are in fact separate and distinct. Of critical importance, directors are entitled to the payment of their attorneys fees in advance of any determination that the directors are entitled to indemnification.

 

An interesting July 3, 2012 Ohio Supreme Court opinion (here) highlights the critical distinction between advancement and indemnification and examines the circumstances under which directors are entitled to advancement.

 

Background

Samuel M. Miller (Sam M.) is a 25% shareholder and director of Trumbull Industries, a plumbing supply company. Sam M. is also Trumbull’s Vice President of Sales. Murray Miller (Murray) and Samuel H. Miller (Sam H.) are also Trumbull shareholders and directors. 

 

In 2002, a dispute arose in which Murray and Sam H. alleged that Sam M. had usurped a corporate opportunity for his personal advantage. In February 2003, Murray and Sam H. filed a complaint against Sam M. (among others) seeking injunctive relief and damages.

 

In September 2005, Sam M. sent Murray and Sam H. a memo informing them that he had reimbursed himself out of the Trumbull corporate treasury for the costs of defending himself against their complaint, after executing an “undertaking” under Ohio Code Section 1701.13 (E)(5)(a) to repay the amounts if it is determined he is not entitled to indemnification. The undertaking incorporated the specified statutory undertaking language.

 

In December 2006, both sides sought a judicial declaration regarding Sam M.’s rights to indemnification for his legal fees. Following an almost impossibly complicated procedural odyssey, the indemnification case made its way to the Ohio Supreme Court.

 

The July 3 Opinion

In a 6-1  majority opinion dated July 3, 2012 and written by Chief Justice Maureen O’Conner, the Ohio Supreme Court overturned the intermediate appellate court’s holding that the trial court had improperly ordered Trumbull to pay Sam M.’s attorneys’ fees and reinstated the trial court’s finding that Trumbull was in contempt for refusing to pay Sam M.’s attorneys’ fees.

 

In determining Sam M.’s rights, the “Court interpreted Ohio law, but looked to judicial decisions interpreting Delaware law for “insight,” as advancement is a “Delaware specialty.”

 

At outset, the Court made an important distinction, highlighting the fact that Sam M. sought “advancement,” not “indemnification.” Though the parties and the lower courts had used the terms “interchangeably,” the terms, “though related” are “not the same and should not be used as synonymous.”

 

Murray and Sam H. (hereafter, the appellees) argued, in reliance on the Ohio statutory provisions specifying when a director is entitled to indemnification, that Sam H. was not entitled to have his attorneys’ fees paid because he was not being sued for any “act or omission” he committed on behalf of the corporation. The appellees also argued that he was not entitled to indemnification of his fees because his acts were not within the protection of the business judgment rule.

 

The Supreme Court rejected these arguments, based as they were on the statutory standards for the entitlement to indemnification, on the grounds that “the advancement of fees is neither determined by nor dependent on whether a director is entitled to indemnification.” The only issue, the Court said, is “whether Sam M. is entitled to advancement of his expenses,” not whether he will ultimately be entitled to indemnification based on the adjudication of the allegations against him.

 

The Court said that Trumbull could not avoid its statutory advancement obligation because Sam M.’s conduct, if proven, “would foreclose indemnification due to an alleged breach of his fiduciary duties.” Allowing a corporation to “avoid advancement by asserting that a director breached his fiduciary duty would make the advancement statutory provisions pointless.”

 

The only prerequisite for advancement is the execution of the statutorily required undertaking to repay, which Sam M. had done. When the director seeking advancement has executed the undertaking, “the corporation is required to advance.”

 

The Ohio statutes provide, the Court noted, that a corporation may opt-out of these mandatory advancement provisions by adding a provision to its articles of incorporation specifying that the advancement provisions do not apply. However, Trumbull had not adopted an opt-out provision in its articles, and therefore, given that Sam M. had executed the required undertaking, there was no basis for Trumbull to withhold advancement.

 

Justice Terrence O’Donnell dissented, arguing that Sam M. was not entitled to advancement because the wrongful acts of which he was accused had allegedly been undertaken in his personal capacity or in his capacity as an officer (rather than as a director) of Trumbull. Either way, the acts had not been undertaken in the sole capacity (i.e., as a director) for which he was entitled to advancement under the relevant statutory provisions.

 

Discussion

In my factual recitation above, I omitted the lengthy procedural history of the indemnification case. If nothing else, the tortured procedural history shows how contentious these kinds of disputes can become. Indeed, the original claim underlying the indemnification fight is now in its tenth year. The contentiousness in turn illustrates another point, which is the importance of working out the details of advancement and indemnification arrangements when all is calm and skies are clear. It is a terrible time to try to sort these issues out after the storm has hit.

 

The majority opinion did emphasize that under the relevant statutory provisions, Ohio corporations can amend their articles of incorporation to opt-out of the mandatory advancement provisions. However, I suspect that companies addressing these issues when all is calm are unlikely to include such an opt-out provision in the articles of incorporation. At that point, none of the directors have any way of knowing whether or not they might be the ones that would want to have their defense fees advanced, and so they would be unlikely to adopt such an opt-out provision.

 

After a dispute has arisen, a corporation or some of its board members may well want to withhold advancement from one or more directors. However, that simply underscores how important it is that the right to advancement is automatic. If it were any other way, after a falling out or during an intra-board dispute, a group of directors could act together to deprive another director of his or her rights and ability to defend themselves.

 

The automatic operation of the advancement requirement ensures that directors are able to defend themselves, even when (or perhaps particularly when) the allegations against them are serious. From time to time, controversies can arise when corporations are obliged to provide funds for directors’ defense when the directors are the subject of high-profile allegations. For example, as I discussed here, there were questions when BofA funded the defense for former Countrywide CEO Angelo Mozillo. Because the advancement rights are automatic (subject to only to the undertaking requirement), directors cannot be deprived of their defense protection even if they have become involved in controversy or they are the target of intra-corporate vindictiveness.

 

The advancement right is also very durable. In a July 30, 2008 Delaware Chancery Court opinion (here) in which then-Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Strine held that under Delaware statutory law and the applicable by-law provisions requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.

 

Perhaps the most important aspect of the majority opinion is its insistence on the distinct difference between advancement and indemnification. All too often, observers and commentators, like the parties to this dispute and like the lower courts here, blur the distinction between the two. The two, though related, represent distinct statutory rights available for the protection of directors. Moreover, as the Court here emphasized, if mere allegations which if proven might provide a basis for withholding indemnification from a director were sufficient to deprive the director of his or her right to advancement, the statutory provisions relating to advancement would be meaningless. Advancement is available so that directors can defend themselves, without which the right of indemnification itself might also be rendered meaningless.

 

It should not be lost here that a critical prerequisite to the right of advancement is the provision of the undertaking to repay. This requirement is not a meaningless procedural step. Directors taking advantage of the right to advancement may in fact be required to repay amounts advanced in the event of a judicial determination establishing they are not entitled to indemnification. In many instances, when the time comes for repayment, the individuals lack resources out of which the might make the repayment. However, from time to time, corporations do successfully assert and establish their right of repayment. 

 

These issues surrounding the obligation to repay have recently been in the limelight, following the insider trading conviction of Rajat Gupta. Peter Lattman’s June 18, 2012 New York Times article discussing Goldman Sachs’ payment of Gupta’s legal fees and of its rights or repayment for the fees in the wake of Gupta’s conviction can be found here.

 

A potentially important issue that the majority opinion sidestepped but that the dissenting opinion stressed is the question of whether or not Sam M. was acting in capacity for which he is entitled to advancement when he engaged in the alleged misconduct of which he is accused. The majority opinion essentially said that it did not have to address the question because it had not been properly preserved on appeal. Had the majority addressed the question, the outcome of this appeal could well have been quite different.

 

For a basic overview of indemnification rights and the relationship of indemnification to D&O insurance, refer to my earlier post on the topic, here. I published the earlier post as part of my series on the “Nuts and Bolts” of D&O insurance; the complete series can be accessed here.

 

A July 2012 memorandum from the Squire Sanders law firm discussing the Ohio Supreme Court’s opinion can be found here.

 

Criminal Charges Against Former Officers of Failed Bank: It has been weeks since the FDIC has filed a civil suit against the former directors and officers of a failed bank; as reflected here, the FDIC’s last civil suit was filed in May, and that was the only civil lawsuit the FDIC has filed since April. But the FDIC has not been idle. A grand jury has returned a July 11, 2012 indictment (here) against four former officers of the failed Bank of the Commonwealth, or Norfolk, Virginia, as well as two of the bank’s customers. According to the FBI’s July 12, 2012 press release regarding the indictment (here), the investigation of the bank had been undertaking in collaboration and cooperation with the FDIC’s Office of Inspector General.

 

The Bank of the Commonwealth failed on September 23, 2011. The indictment alleges that the bank had grown rapidly between 2005 and 2009, largely based on the bank’s reliance on brokered deposits. In 2008, the volume of the bank’s troubled loans soared. The indictment alleges that from 2008 to 2011, the criminal defendants allegedly masked the bank’s true financial condition out of fear that the bank’s declining health would negatively impact investor and customer confidence and affect the bank’s ability to accept and renew brokered deposits.

 

To hide the bank’s deteriorating loan portfolio and condition, the defendants  allegedly overdrew demand deposit accounts to make loan payments, used funds from related entities—at times without authorization from the borrower—to make loan payments, used change-in-terms agreements to make loans appear current, and extended new loans or additional principal on existing loans to cover payment shortfalls.

 

The indictment also alleges that bank insiders also provided preferential financing to troubled borrowers to purchase bank-owned properties. These troubled borrowers were already having difficulty making payments on their existing loans; however, the financing allowed the bank to convert a non-earning asset into an earning asset, and the troubled borrowers obtained cash at closing to make payments on their other loans at the bank or for their own personal purposes. The indictment also alleges that troubled borrowers purchased or attempted to purchase property owned by bank insiders These real estate loans were fraudulently funded by the bank.

 

The bank’s former CEO, Edward Woodard, is charged with conspiracy to commit bank fraud, bank fraud, false entry in a bank record, multiple counts of unlawful participation in a loan, multiple counts of false statement to a financial institution, and multiple counts of misapplication of bank funds. The other defendants are charged with a variety of related charges.

 

These charges are far from the first criminal charges the enforcement authorities have filed as part of the current wave of bank failures. As discussed here (scroll down), the federal authorities are also pursuing criminal charges against certain former officers of the failed United Commercial Bank. The FDIC has also filed criminal charges against two former officers of Integrity Bank, as discussed here. There undoubtedly have been other criminal charges as well.

 

It is hard to tell from the outside, but it sure would be interesting to talk to somebody on the inside about when the FDIC upgrades its investigation of the circumstances surrounding a bank’s failure to a criminal investigation. The allegations in the indictment alone do not sound all that dissimilar from the kinds of things that the FDIC and that investors have alleged in connection with many other bank failures that have not involved criminal charges.

 

In any event, there undoubtedly will be other criminal charges to come in connection with other banks. At the same it is interesting that the pace of the FDIC’s filing of civil litigation in connection with the failed banks clearly has tailed off. Again, it is hard to tell from the outside what is going on, but it sure would be interesting to talk to somebody on the inside.

 

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A fundamental tenet of corporate law is that a business corporation is organized and carried on for the benefit of its stockholders.  In recent times, an increasing number of for-profit organizations have formed in order to pursue social and environmental goals. There is a growing investor movement toward the financial support of organizations that have social benefit purposes at the center of their existence. However, it may be difficult for directors and officers of these organizations to pursue these social purposes without running afoul of traditional fiduciary duties requiring corporate managers to maximize shareholder value.

 

In order to address these concerns, a group of lawyers and academics have proposed a new form of enterprise, the benefit corporation. The idea behind this organizational form is to create an enterprise that can utilize the tools of business financing and management to address social and environmental issues. In order to deal with the legal issues involved with organizing a business enterprise for broader goals, the proponents of this idea have crafted Model Benefit Corporation Legislation.

 

Since 2010, the model legislation has been adopted in whole or in part in seven states, including California, New Jersey and Virginia, and is under consideration in a number of others. New York’s version  became law  on February 10, 2012. Although the model legislation’s provisions address a number of issues, the “heart” of the model benefit corporation legislation is its provisions addressing concerns related to potential director and officer liability.

 

In this post, I examine the circumstances that have led to the proposal for the development of the benefit corporation concept; the specifics of the organizational form described in the Model Benefit Corporation Legislation; and the aspects of director and officer liability addressed in the legislation. I conclude with my thoughts about the proposed organizational form, including the implications from both a liability and insurance standpoint.

 

My analysis of these issues relies heavily on the November 16, 2011 paper entitled “The Need and Rationale for the Benefit Corporation” (here).  A number of contributors participated in the creation of this document, but the paper’s principal authors are William H. Clark, Jr. of the Drinker Biddle law firm, and Larry Vranka of Canonchet Group LLC. I also refer below to the Model Benefit Corporation Legislation, which can be found here. Information about benefit corporations generally can be found at the Benefit Corporation Information Center. The January 7, 2012 article in The Economist magazine the first piqued my interest in benefit corporations can be found here.

 

Background

Two recent trends have come together to create the need for a new form of business enterprise. On the one hand, there is a growing class of investors joining the socially responsible investing movement. These investors hope to create a direct social impact through targeted equity and debt investments. (A November 2010 J.P. Morgan study on impact investing can be found here.) On the other hand, for-profit social entrepreneurs, who are interested in pursuing mission-driven businesses, are increasingly common.

 

An earlier initial response to these developments was the 2007 formation of the B Lab, a non-profit organization whose purpose was to devise and implement a certification system for companies interested in distinguishing themselves in order to try to attract the socially focused investors. B Lab promulgated a number of certification standards for these companies. The difficulty is that these standards were to be adopted within the existing legal framework.

 

A critical component of the existing legal framework is the basic principal that business corporations exist to maximize shareholder value. This principal constrains the ability of businesses, at least within the existing framework, to consider the interests of constituencies other than shareholders. To be sure, a number of states, in response to takeover battles in the 80’s, did implement so-called “constituency” statues that enable boards and senior company officials to take in account community interests when considering a takeover bid.  Unfortunately, among the states that have not adopted constituency statues is Delaware, the place of incorporation for many companies. In addition, even in the states that have adopted constituency statutes, there is a dearth of case law interpreting the statutes, and so there is very little guidance on what other interests a board may consider and to what extent. In addition, constituency statutes are often merely permissive, not mandatory.

 

Owing to the absence of clear legal standards in these areas, directors may be hesitant to consider social goals or the interests of other constituencies for fear of breaching their fiduciary duties to shareholders. The legal uncertainties and need for greater clarity have led to the proposal of a new form of business enterprise to address the needs of for-profit mission-driven businesses.

 

The Benefit Corporation

In order to address the legal concerns, reformers have proposed the benefit corporation. The three distinct aspects of the benefit corporation are that it has 1) a corporate purpose to create a material positive impact on society and the environment; 2) expanded fiduciary duties of directors that require consideration of nonfinancial interests; and 3) an obligation to report on its overall social and environmental performance as assessed against third-party standards.

 

These attributes are embodied in the Model Benefit Corporation Legislation, which has provided the basis for the benefit corporation statues that have been enacted in the seven states. (The seven states are Maryland, Hawaii, Vermont, Virginia, California, New Jersey and New York. Four other states are currently considering similar legislation.) 

 

               

Under the model legislation, the benefit corporation is required to have a purpose of “general public benefit” and allowed to identify one or more “specific public benefit” purposes. The model legislation lists seven non-exhaustive possibilities for specific public benefit goals, which include: providing products or services to low income individuals; providing economic opportunities for individuals or communities; preserving the environment; improving human health; promoting the arts or sciences; increasing the flow of capital to public benefit enterprises; or the accomplishment of any other particular benefit to society or the environment.

 

The model legislation further provides that in considering the best interests of the corporation, the directors of the corporation “shall consider the effects of any action or inaction” on the shareholders; the employees of the corporation; the customers; community or societal factors; the local and global environment; the short-term and long-term interests of the benefit corporation; and the ability of the benefit corporation to accomplish its general and specific benefit purposes.

 

In addition to providing this broad array of factors directors must consider, the model legislation provides certain protections for the benefit corporation directors (and officers). First, the model legislation provides that consideration of the interests of all stakeholders shall not constitute a violation of the general fiduciary duty standards for directors. Second, the model legislation expressly exonerate the directors and officers from monetary damages for any action taken in compliance with the preexisting standards for director duties; and for the failure of the benefit corporation to pursue or create its stated general or specific public benefit. These provisions are intended to eliminate directors’ concerns that they could face damages liability for the enterprise’s failure to fulfill its purposes or for considering the interest of constituencies other than shareholders.

 

The model legislation does provide for a form of injunctive relief action, to require the benefit corporation to live up to its commitments. Under these provisions, shareholders have the right to bring a legal action in the form of a “benefit enforcement proceeding” on the grounds that a director or officer has failed to pursue the stated general or specific purpose or failed to consider the interest of the various stakeholders identified in the statute. However, only shareholders or directors can bring a benefits enforcement proceeding; beneficiaries of the corporation’s public purpose have no right of action. The exclusion of any right of action by third parties protects the benefit corporation from unknown, expanded liability that might create disincentives to becoming a benefit corporation

 

Discussion

The purpose of the benefit corporation is to provide an appropriate enterprise vehicle for for-profit mission-driven businesses. Among the objectives in structuring the benefit corporation form is the need to address critical issues regarding the duties and potential liabilities of directors and officers. The key objectives of the model legislation are to ensure that directors and officers of the benefit corporation do not incur liability for considering the interests of constituencies other than shareholders and to ensure that the directors and officers do not incur monetary liability for allegedly failing to fulfill the organization’s general or specific benefit purposes.

 

It is important to note that although the model legislation provides that the directors and officers cannot be held liable for damages under the benefit corporation provisions, the benefit corporation provisions do not exempt the directors and officers from liability for violating general standards of fiduciary care. The exemption from monetary damages in the model legislation provide only that directors is “not personally liable for monetary damages for (1) any action taken as a director if the directors performed the duties of office in compliance [existing statutory provisions specifying the duties of directors generally]; or (2) failure of the benefit corporation to pursue or create general public benefit or specific public benefit.” Parallel provisions provide similar protections for officers. 

 

The point is that the exemption from monetary damages under the benefit corporation provisions does not exempt the directors and offices from claims for damages for violation of their general fiduciary duties. By the same token, however, the model legislation specifies that the directors and officers of the benefit corporation cannot be held liable for considering the interests of constituencies other than shareholders.

 

The model legislation does provide for a “benefits enforcement action,” for shareholders to pursue injunctive relief if the organization is not pursuing its benefits objectives or providing required reporting. Even though this action does not allow for damages, it does create a context within which defense costs could be incurred.

 

In other words, not withstanding the liability protections in the model legislation, directors and officers of a benefit corporation continue to face the possible liability exposures and defense expense exposures.

 

As a for-profit venture organized to pursue a public good, a benefit corporation does not really fit within the usual D&O insurance framework, which divides the world between non-profit and commercial enterprises. In addition, the benefit corporation regime has unique aspects that could have insurance implications, such as the possibility of a benefit enforcement action.

 

In just over two years, seven states have enacted legislative provisions allowing for benefit corporations. Implementing legislation is under consideration in several more states. It seems likely that adoption of benefit corporation legislation will become more generalized in the months and years ahead. It also seems likely that as the benefit corporation form become more widespread that insurers will be called upon to address the insurance needs of this new type of enterprise. The unique features of these organizations raises the possibility that new insurance solutions, targeted to the unique needs of these kinds of companies, will be required.

 

In any event, benefit corporations represent an interesting innovation on the corporate enterprise landscape. If, as seems likely, more states adopt benefit corporation enabling legislation, the issues involved in addressing these companies’ insurance requirements will become an increasingly common concern.

 

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The advisory shareholder vote required under the Dodd Frank Act went through its first cycle in 2011, and by and large most companies’ shareholders approved the companies’ executive compensation plans. Only about 45 companies (less than 2%) received negative “say on pay” votes from a majority of investors. But that does not mean that the say on pay process was an empty exercise. Indeed, as we move forward in the second year of advisory votes, the impact of the say on pay process may now start to tell.

 

First, as detailed in a February 22, 2010 Wall Street Journal article entitled “ ‘Say on Pay’ Changes Ways” (here), many of the companies that sustained negative say on pay votes last year “are working hard to avoid an embarrassing repeat as annual meeting season begins again.” According to the Journal article, “the boards of many of the companies that failed the votes have consulted with investors and hired outside compensation advisers and proxy solicitors” and some “have made broader management changes that could help remedy performance issues at the heart of some shareholder concerns about pay.”

 

According to the Journal article, two of the companies that sustained negative say on pay votes last year – Beazer Homes USA and Jacobs Engineering – have already obtained positive say on pay votes this year with over 95% shareholder approval

 

The impact of the first say on pay cycle was not limited just to companies that sustained a negative vote last year. Institutional investors themselves have also been affected by the first cycle of votes. In a very interesting February 22, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Lessons Learned: The Inaugural Year of Say-on-Pay” (here), Anne Sheehan, the Director of Corporate Governance at the California State Teachers’ Retirement System (CalSTRS), comments that “the first year of Say-on-Pay was a learning opportunity as it helped us to refine our voting process for future years.” Her article makes it clear that not only did CalSTRS vote against many company’s pay packages last year, it may well do so again this year. In 2011, CalSTRS cast 23% percent negative say on pay votes.

 

In her post, Sheehan explains, with reference to CalSTRS, that “we believe that poorly structured pay packages harm shareholder value by unfairly enriching executives at the expense of owners – the shareholders.” She explained that CalSTRS “predominately voted against companies’ Say-on-Pay proposals because of disconnects between pay and performance.” In consideration of its 2012 votes, CalSTRS intends to focus on companies whose peer group comparisons lead to pay packages targeted to produce above the median, “particularly when companies targeted the 75^th or 90^th percentile.” CalSTRS is concerned about companies that are “over paying for on-par or below-average performance.”

 

Sheehan’s post and her description of the approach of CalSTRS heading into the second say-on-pay cycle makes it clear that there will be continued pressure on many companies regarding their compensation practices and disclosures, not just the relatively few companies that sustained negative votes in 2011.

 

The threats companies face as result of the say on pay process include not just investor scrutiny, but also even the possibility of shareholder litigation. As discussed in prior posts on this blog (refer for example here and here), some of the negative say on pay votes last year were followed by shareholder litigation regarding executive compensation issues.

 

To be sure, the number of these cases was relatively small, perhaps fewer than ten out of the roughly 45 companies that had negative say on pay votes. And many of these suits have been dismissed based on the application of the business judgment rule. In effect, courts have generally proceeded on the assumption that compensation is a matter within the board’s business judgment, although at least one court in a case involving Cincinnati Bell did decline to dismiss a say-on=p-pay lawsuit.

 

As discussed in a February 5, 2012 memo from Kenneth B. Davis, Jr. and Keith L. Johnson of the Reinhart Boerner Van Deuren law firm entitled “Say-on-Pay Lawsuits – Is This Time Different?” (here), “boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay note.” In particular, the authors contend, “companies that fail to adequately explain and support their compensation awards will increasingly find themselves targeted for follow-up, through whatever means and remedies investors have available.”

 

The memo authors’ views in this regard to a large extent mirror the sentiments Sheehan expressed in her blog post. The authors state that “the early reports are that with the experience of the first season of say-on-pay behind them, many institutional investors are now prepared to take a more active role in identifying and opposing the compensation arrangements they find troublesome.” Among the motivations behind this focus on compensation is a perception that the say-on-pay focus may be “the best remaining avenue for challenging ineffective boards.” For that reason, many institutional investors intend to “ramp up focus” on the votes and in particular to “vote against boards that are unresponsive to shareholder concerns.”

 

As a result of all of this, the authors conclude that disgruntled investors unhappy with board responsiveness on compensation issues will continue to consider litigation as an option. In fact, the authors “expect the volume of this litigation will likely increase.” Companies “should continue to consider litigation risk among the many costs of failing to win substantial shareholder support for their executive compensation arrangements.”

 

The authors conclude that in order to reduce litigation risk and increase investor support, boards should “improve their disclosures around executive compensation, engage with and respond to legitimate shareholder concerns and attend to removing both conflicts of interest and behavioral biases from the board’s compensation oversight practices.”

 

How all of this will play out remains to be seen. At a minimum, it seems clear that even though the say on pay vote is merely advisory, it remains a matter of significance even as it enters its second year. Institutional investors clearly intend to try to use the vote as a means to try to address executive compensation issues. The continued focus has a number of significant implications for companies, including in particular the possibility of litigation risk for companies sustaining a negative say on pay vote.

 

Special thanks to Ken Davis for sending me a copy of his interesting article on Say-on-Pay litigation.

 

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One of the most basic notions in our legal system is that liability attaches only to those who act with intent or knowledge. But as detailed in a front-page September 27, 2011 Wall Street Journal article (here), Congress has in recent decades enacted numerous provisions imposing criminal liability regardless of intent. Among the many troubling aspects of this trend are the implications for corporate directors and officers, who often are the target of these strict liability provisions and who increasingly have liability imposed on them for matters in which they were not involved and of which they were not even aware.

 

As the Journal article explains, a “bedrock principle” of our legal system is that criminal liability cannot be imposed without “mens rea,” or a guilty mind. But as the article details, Congress has “repeatedly crafted laws that weaken or disregard the notion of criminal intent.” As a result, things that “once might have been considered simply a mistake” are “now sometimes punishable by jail time.”

 

The article cites a number of recently enacted criminal provisions, particularly certain enactments regarding wildlife issues and firearms violations. One example cited refers to the imposition of a 15-year criminal sentence for possession of a single bullet (in violation of firearms restrictions for convicted felons).

 

Among the areas the article references that have seen the enactment of these types of provisions is white collar crime. The article specifically cites the provisions of the Sarbanes Oxley Act that make it “easier for prosecutors to bring obstruction of justice cases related to the destruction of evidence.” The article explains how these provisions passed as part of the larger bill without full or appropriate consideration of the implications.

 

The Sarbanes Oxley Act provision cited is far from the only recent statutory enactment or judicial development that potentially imposes liability on corporate officials without culpability. Indeed, just a few days ago, on September 13, 2011, another Wall Street Journal article entitled “U.S. Targets Drug Executives” (here) described how federal regulators have increasingly been using the judicially developed “responsible corporate officer doctrine” to pursue criminal prosecutions against corporate executives for federal food and drug law violations.

 

As I discussed in my own earlier look at the “responsible corporate officer doctrine” (here), courts have the doctrine to impose criminal liability on corporate officials who were not involved in or even aware of the violations. (The word “responsible” in the name of the doctrine references responsibility for the corporation not for the conduct.) As the September 13 Journal article details, the use of this doctrine can not only result in the imposition of criminal fines and penalties, but the convictions obtained in reliance on the doctrine can then be used to exclude convicted executives from Medicare and Medicaid, in effect turning their conviction into “career-ending punishment.”

 

As discussed here, the doctrine’s application has not been limited just to food and drug violations but has also been extended to violations of environmental law as well, and also has been used as the basis for the imposition of civil liability as well as criminal liability.

 

Nor do these instances represent the only examples of imposition of liability without culpability – to the contrary, they are consistent with a growing willingness of government regulators and prosecutors to try to impose liability without regard to involvement in or awareness of the alleged wrongdoing. For example, there have been multiple instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged wrongdoing.

 

First, as described here, the SEC has now on several occasions used its authority under Section 304 of the Sarbanes-Oxley Act to “clawback” compensation corporate executives earned a time when their companies were committing accounting fraud. For example, most recently former Beazer Homes CFO James O’Leary was compelled to return $1.4 million in bonus compensation even though he was himself not charged with any wrongdoing in connection with the company’s accounting fraud. As I noted in my prior post, though the SEC’s implementation of the compensation clawback is statutorily authorized, the imposition of a forfeiture without culpability or fault raises troubling questions, including basic questions of fairness.

 

In a separate development discussed here, the SEC recently filed an enforcement action seeking to impose control person liability on two officers of Nature’s Sunshine Products for the company’s Foreign Corrupt Practices Act violations – even though the two officials were not alleged to have any involvement in or awareness of the wrongful conduct.

 

Unfortunately, this trend toward the expansion of liability without culpability seems to be growing. Indeed, the Dodd-Frank Act greatly expands the compensation clawback ,  by requiring the major exchanges to adopt requirements for all listed companies to adopt provisions for the recovery in the event of a restatement of bonus compensation from any current or former executive officer who earned bonus compensation during the three years preceding the restatement.

 

The September 27 Journal article suggests that Congress is creating these types of exposures simply because it is neglecting to consider traditional intent requirements. I am not so sure, particularly when it comes to liability for corporate officials, as there seems to be this pervasive notion that corporate officials deserve liability and are getting off “scot free” and this in turn is leading to an increasing willingness to impose liability because of the position rather than because of their culpability.  

 

In recent months, I have taken on several commentators who have tried to argue that corporate officials need to be held liable more often (here), or that there is something wrong with our legal system when corporate officials cannot be held liable more frequently (here). I am concerned that general presumption that corporate executives are somehow blameworthy and deserving of liability are behind this trend toward imposing liability on corporate executives without actual culpability.

 

There is an unfortunate trend in our society to assume that when something has gone wrong that somebody has to be punished. This general proclivity to look for someone to blame is exacerbated by a general willingness to demonize corporate “fat cats,” which in turn leads some to conclude that corporate executives deserve liability because of their position, without regard of whether they actually did anything culpable.

 

I appreciate that many believe corporate executives need to be held accountable. Nevertheless, I am concerned that as a result of the increased tendency to impost liability on corporate executives without culpability, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances when they have done nothing themselves to deserve it. Scapegoating any individual – even a corporate executive – for circumstances in which they were not involved and of which they were not even aware is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

Along with all the other concerns, these types of proceedings may also raise D&O insurance coverage issues. Corporate officials in most instances would not have insurance coverage for the various fines and penalties imposed in these actions or for disgorged compensation. But the executives might well seek insurance coverage of their legal fees incurred in defending themselves in these actions. One question that might be asked in many of these types of cases is whether or not the proceedings involve an alleged “Wrongful Act” as is required to trigger coverage. Should these questions arise, these executives will want to be able to argue that the applicable D&O policy in any event covers them for allegations against them in their capacities as directors and officers “and in their status as such.”

 

Bank Director and Officer Defenses: As I have noted in prior posts (most recently here), there are now a growing number of actions against the directors and officers of failed banks brought by the FDIC as the failed bank’s receiver. The defenses available for these individuals and related considerations (including indemnification and insurance) are discussed in a brief, useful (date) memo from the Dechert law firm, entitled “Bank D&O Defense Manual” (here). The memo provides background on the FDIC’s approach to director and officer liability, the well as on the legal theories on which the FDIC will proceed and the defenses available to the directors and officers.

 

Speakers’ Corner: On October 5 and 6, 2011, I will be in Cologne, Germany participating in C5’s Sixth European Forum on D&O Liability Insurance. I will be participating in a panel on the first day discussing the evolution of class actions in the U.S. and Europe. Joining me on the panel will be Rick Bortnick of the Cozen O’Connor law firm; Guillaume Deschamps of Marsh, S.A. (France) and Prof. Dr. Roderich Thümmel of the Thümmel Schültze law firm.  Background regarding the event, including the complete agenda and registration information, can be found here.

 

If you will be attending the conference, I hope you will take time to greet me, particularly if we have not previously met.

 

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Yahoo’s board members may or may not be “doofuses” as departed Yahoo CEO Carol Bartz declared after they sacked her, but the one thing for sure is that the events surrounding her firing, and the more recent CEO turnover at H-P, sure have folks riled up. Whatever else you want to say about these events, they certainly have provoked an interesting dialogue about the role and function of corporate boards.

 

A particularly interesting discussion of these issues appears in Alison Frankel’s September 23, 2011 article on Thomson Reuters News & Insights entitled “Want More Board Accountability? It Won’t Come Through Litigation” (here). Her opening salvo in her call for board reform is that shareholders have “precious little power over corporate directors.” She notes that while derivative lawsuits “give investors an opportunity to blame boards for breaching their duties, “ all the suits really do is to provide shareholders “an opportunity to air allegations without a lot of hope they’ll make difference.”

 

Frankel is particularly concerned that when derivative suits are filed, board members are able to rely on the business judgment rule and also on the procedural requirement that shareholders first make a demand on the board to take up the claim before pursuing the lawsuit. She also is concerned that derivative litigation defense expenses and rare settlement amounts are often paid by insurance. As a result she says, “there’s really little consequence for board members from even the rare derivative suit that ends with a sizeable payment to shareholders.”  She concludes by questioning how boards can be reformed “when board members have so little incentive to change.”

 

Frankel makes a number of interesting points, and as usually is the case for her, she makes her points well. Nevertheless, I have a number of comments about her article. I want to emphasize at the outset that by offering these comments I mean no disrespect -- I am in fact a huge fan of Frankel’s.  I offer these thoughts here purely in the interests of the exchange of ideas.

 

I should also acknowledge my biases. I have basically spent my entire career involved one way or the other with the interests of corporate boards. I tend to look at things from the perspective of corporate officials, which undoubtedly affects my view – although I do not think that disqualifies my opinions. What it means is that when some people think of corporate board members, they can only think of fat cats in fancy suits lighting cigars with hundred dollar bills. Whereas I think of the conscientious, hard-working, well-intentioned men and women I have known over the years who try hard to do what is best for their companies.

 

There is some irony that this debate is arising in the context of two recent board actions to fire their companies’ CEOs. It used to be that boards were criticized for being too cozy with the CEOs they were supposed to be supervising. Now Yahoo’s and H-P’s board are being criticized for the actions they took in throwing their CEOs out. I think a fair case could be made that these events played out the way they did not because the boards lack “incentives” to change as Frankel asserts, but rather because the boards are under excruciating pressure and feel a tremendous urgency to act forcefully. We may or many not agree with their actions or the way they went about it, but no one can question their willingness to act aggressively to try to make changes they think are necessary.

 

I think it is important to keep the extraordinary pressure facing board members today in mind when thinking about the desirability of trying to hold directors more accountable through shareholder derivative litigation. My own view is that it would be highly detrimental to the general aims and purposes of the corporate business enterprise if the defensive safeguards to derivative litigation were significantly reduced.

 

The expression of the need to “hold boards accountable” represents fine sentiment. But does anyone think that the economic purpose of the corporate business enterprise would be advanced if corporate officials could more easily be hauled into court and more frequently forced to defend their business decisions in court? In particular, does anyone really think that the increased threat of litigation would produce better business results and outcomes? And what would this omnipresent threat of litigation do to corporate decision-making if at the same time these corporate officials could not resort to insurance to protect themselves?

 

Personally, I have an experienced-based bias against anything that would encourage more litigation. I began my career litigating business cases. It is very hard to come in contact with our civil litigation system without concluding that the litigation process in our country is a colossal waste of time, energy and resources. All too often, the only ones who benefit from the system are the lawyers, and even they hate it. While I will concede that there are meritorious cases, it is the rare case indeed that produces benefits even remotely commensurate with the hideous waste of resources the process entails. It is impossible for me to believe that removing barriers to litigation will do anything to improve corporate performance or board functioning.  

 

It is far likelier that increased litigation threats and liability exposures will undermine the kind of decision-making our companies need to be able to compete in the global economy. It could also exacerbate the enormous pressures that directors already face and magnify the kinds of pressures that arguably caused the Yahoo and H-P boards to act precipitously in their recent actions.

 

The fundamental issue here is the question of what it means to “hold boards accountable.” I start with the proposition that the corporate enterprise is a financial venture pursuing a business purpose and run by a group of individuals. Investors’ participation in this venture is purely voluntary and entirely optional, and based on the investors’ own assessment of the venture and the individuals trying to run it.  Whether to invest, to stay invested or to stay away altogether are the tools investors have – and they are powerful tools, as in the end access to investment capital could be determinative of whether or to what extent the venture succeeds. Investment selection is the truest and most effective form of shareholder democracy.

 

One valuable thing that has emerged from the recent events and the ensuing discussion is a renewed appreciation for the importance of board functioning. An effective board is an important part of any successful corporate enterprise. But rather than producing bigger cudgels with which to chastise boards of lagging enterprises, what we need are better tools to understand how to identify companies with effective boards. In the long run, picking winners rather than punishing losers will be better for individual business enterprise and for our general economic well-being.

 

I would like to see improved board functioning as much as anyone else. In a highly competitive global economy it is going to be increasingly important for companies to have wise and visionary leadership. But subjecting corporate stewards to increased hindsight second-guessing in a courtroom will do little to bring that type of leadership about.  

 

My earlier post discussing the question of whether directors should be held liable more often can be found here.

 

Looking in the Hermit Kingdom:  According to a September 17, 2011 article in The Economist magazine (here), North Korea is once again facing a severe food shortage. The article examines the question of how a regime that so persistently leaves its population in hunger and misery remains so entrenched. The article speculates that population distribution and transportation shortcomings have internally isolated the country’s underclass and minimized the risk that they might act collectively.

 

A question worth asking is what the country’s leadership is doing to address the current crisis. The answer is that, well, they are looking at things. Indeed, based on pictures published in North Korean newspapers, looking at things is the country’s leader’s principal occupation – so much so that there is a website descriptively and accurately entitled “Kim Jong-il Looking at Things.” The site, which notes that “the dear leader likes to look at things,” consists of pictures of, well, Kim Jong-il looking at things. What kinds of things? A fish, umbrellas, doner kabab, scientists, glass bottles, corn, chemicals, bread…I guess there are a lot things to look at when you a “Supreme Leader.”

 

According to Wikipedia (here), Kim Jong-il’s official biography claims that his birth “was foretold by a swallow, and heralded by the appearance of a double rainbow over the mountain and a new star in the heavens.”   Many North Koreans believe that he has the "magical" ability to "control the weather" based on his mood.  In 2010, the North Korean media reported that Kim's distinctive clothing had set worldwide fashion trends.

 

The whole bizarre situation would be funny if it weren’t so tragic.

 

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In an August 2, 2011 post on the New York Times  Dealbook blog entitled “Ex-Directors of Failed Firms Have Little to Fear”(here), Ohio State University Law Professor  Steven Davidoff voices his consternation that the former directors of Bear Stearns and Lehman Brothers seemingly will be able to “continue their prominent careers.” Davidoff seems miffed that the former board members of these failed firms have not only been able to get on with their lives but many of them have continued to serve as board directors. Others maintain roles of prominence in academia or business. (Bear Stearns of course did not actually fail but for simplicity of expression in this post I have referred to it using that term.)

 

Davidoff acknowledges that the financial crisis that accompanied these companies’ failures was an “enormously complex event” and that officials at these failed firms can argue that “it was the crisis itself – not poor management or inadequate board supervision – that caused their firm’s demise.” Given that, Davidoff is “not arguing that these directors be tarred and feathered or that they should not be able to earn a living.” He is just suggesting that “at a minimum…other public companies might be more hesitant to keep these failed directors on their boards.”

 

Davidoff’s column does strain to maintain a balanced point of view, but there is nevertheless an unmistakable underlying assumption that these former board members should be shunned or otherwise punished as a result of their former firms’ failures. Davidoff's apparent thesis is consistent with a prior post of his, in which  he argued that directors should be held liable more often, a point of view with which I disagreed here. I also have some concerns about Davidoff's latest post, which I have outline below. I acknowledge that I have certain biases, which I outlined in my response to Davidoff's prior post. My concerns with the latest post are as folllows.

 

First, the SEC has the authority to bring enforcement actions and, among other things, to impose lifetime bans on individuals from future service as board members of public companies. The SEC has not brought any such action against these individuals, presumably because it does not believe it could bring a meritorious claim against them. Indeed, these individuals have not been found blameworthy or culpable in any way by any legal authority in connection with the demise of these two firms

 

Second, there is a peculiarly American notion that is something has gone wrong, then somebody must be punished – even if the designated scapegoat is not directly to blame for what has gone wrong. But it seems to me that little purpose would be served by forcing these persons onto the shelf and out of productive contributions to corporate life. Stigmatizing them would accomplish nothing, except perhaps satisfaction of some tribal atavistic urge for retribution.

 

It bothers Davidoff that these individuals have been getting on with their lives and in particular that there these individuals apparently have not taken a permanent and disqualifying hit to their reputations. Davidoff ascribes this to the alleged “decline in importance of reputation on Wall Street.”

 

I suspect strongly that these individuals would have a far different view of whether or not their have been consequences for them as a result of the firms’ failures, and in particular I suspect they would have a lot to say on the specific topic of reputation.

 

Even though these individuals have not been found to have done anything wrong, I am quite certain that these individuals’ lives have been quite disrupted as a result of these firms’ collapses. Not only has there been the harsh scrutiny they have all had to face, but there has also been a seemingly endless procession of legal events and proceedings. These individuals are undoubtedly spending more time than is healthy in the company of lawyers.

 

I simply cannot agree that reputation has declined in importance, on Wall Street or anywhere else. For several years I have participated in the Stanford Law School Directors College, in connection with which an attendee survey is conducted in which, among other things, the attendees express their concerns about governance issues. An overwhelming majority of attendees indicate that their biggest concern with respect to problems at the companies with which they are associated is not the risk of liability as such, but the risk to their reputations.

 

Most corporate directors have spent their entire lives building their professional reputations and they take them very seriously. None of the former directors affiliated with Bear Stearns and Lehman Brothers can escape their association with those firms’ demises.

 

The fact that these individuals have been able to get on with their lives despite these failure of their former firms can be interpreted in a number of ways. One way is to conclude that in the “the old boy network of Wall Street,” as Davidoff calls it,  the corrupt fat cats complacently overlook each others’ peccadillos while lighting cigars with $100 bills. Another way to look at is that the kinds of individuals who serve on public company boards often are highly accomplished individuals whose talents and skills are sufficient that their services are still valued in other contexts despite the tarnish that comes even with association with an event like the collapses of Bear Stearns and Lehman Brothers.

 

It seems to me that Davidoff’s real gripe is not really with the individuals themselves but rather is with the rest of the corporate, academic and business world, which just doesn’t think, as he does, that these individuals really ought to be more seriously stigmatized for their association with the failed firms. Perhaps these other organizations can see that these individuals have not been found culpable in any way for what happened at Bear Stearns and at Lehman. Perhaps these other organizations, motivated to act in their own best interests, value the service of the individuals for all of their skill, knowledge and experience,  notwithstanding their association with Bear Stearns and Lehman.

 

The bottom line for me is that I see no value in demonizing individuals who have not been found to have done anything wrong. To me, allowing on the one hand that these individuals shouldn’t be tarred and feathered and should be able to earn a living, but on other hand suggesting that their should be some things they shouldn’t be allowed to do is like arguing that they should be allowed to continue their lives, but should just have to wear some type of scarlet letter for which they are universally shunned. I just can’t get on board with that.

 

There are plenty of legal mechanisms in our country for determining culpability and imposing penalties. I am very wary of any suggestion that there should be social penalties outside of those processes.

 

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For many years, one of the fundamental goals of shareholder rights activists has “proxy access,” which would require corporations to include shareholder nominated board candidates on the company’s proxy ballots. Last year, in the wake of the Dodd-Frank Act, the SEC promulgated rules facilitating shareholder director nominations under certain circumstances. However, on July 22, 2011, in an opinion that called the SEC’s rulemaking “arbitrary and capricious” and reflected sharp criticism of the agency, a three-judge panel of the District of Columbia Court of Appeals struck down the SEC’s rule. The opinion, which can be found here, makes for some interesting reading and raises some potentially significant implications.

 

Background

Shareholder activists have been lobbying for proxy access for years. As part of the sweeping financial reform encompassed in the Dodd-Frank Act, Congress provided the SEC in Section 971 of the Act with authority to promulgate proxy access rules. On August 25, 2011, the SEC adopted rules implementing this provision. Rule 14a-11 would have provided shareholders holding at least three percent of the voting power of a company’s securities who have held their shares at least three years with the right to have their director nominees included in the company’s proxy materials.

 

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules. On October 4, 2010, the SEC issued a stay of the rule’s effectiveness pending the court’s review. 

 

The July 22 Opinion

In an opinion written by Judge Douglas Ginsberg for a three-judge panel, the D.C. Circuit held that the SEC has acted “arbitrarily and capriciously” in adopting the proxy access rules. In language that was presented a particularly harsh rebuke to the SEC, the court said that:

 

We agree with petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again …adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commentators.

 

The court seemed particularly concerned with the costs companies would incur as incumbent directors sought to defeat the shareholders’ electoral challenge, and with the SEC’s supposed failure to take those costs into account. The court said “although it might be possible that a board, consistent with its fiduciary duties, might forego expending resources to oppose a shareholder nominee – for example, if it believes the cost of opposition would exceed the cost to the company of the board’s preferred candidate losing the election, discounted by the probability of that happening – the Commission has presented no evidence that such forbearance is ever seen in practice. “

 

The court was also critical of the SEC for failing to take into account the likelihood that the proxy access process might be used by shareholders with special interests to pursue their own agendas, at the expense of other shareholders. The court said that “the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause the companies to incur costs even when their nominee is unlikely to be elected.”

 

The court granted the business groups’ petition and vacated the SEC rules.

 

Discussion

Both the court’s holding and the language it used have important implications for proxy access and for the SEC’s future rulemaking efforts.

 

With respect to the SEC’s proposed rule, the agency now has to decide whether to appeal the D.C. Circuit’s ruling or to try remedial efforts to try to address the D.C. Circuit’s  concern. The prospects for addressing all of the court’s concerns seem daunting. As a former SEC general counsel quoted in the July 23, 2011 Wall Street Journal article about the decision (here) put it, “given the number of objections the court had, the amount of work would be very substantial and it may just be impossible.”  It may be that at least this latest effort to implement proxy access has hit an insurmountable obstacle.

 

But beyond the proxy access question, the D.C. Circuit’s decision has important implications for SEC rulemaking generally. The court went out of its way to rebuke the SEC for its repeated failure to address legal requirements for the agency’s rulemaking. According to the Journal article, the July 22 opinion represents “the fourth time in recent years the same appeals court has invalidated an agency rule on similar grounds.”

 

The D.C. Circuit’s criticism of the agency’s rulemaking and its insistence on a high bar for rulemaking compliance comes at a time when the SEC is laboring under a significant rulemaking burden due to the requirements of the Dodd-Frank Act and at a time when the agency is also coming under significant budgetary constraints. The SEC will have to move forward to try to meet the Dodd-Frank rulemaking requirements with awareness of the harsh scrutiny its rules will face in the appellate courts.

 

Shareholder activists quoted in the various news articles commenting on the D.C. Circuit’s opinion suggest they will continue to try to press ahead on proxy access. It remains to be seen how the SEC will respond. But for now, proxy access has been tabled, and it may be some time before this or another initiative resuscitates the initiative.  

 

The Morrison & Foerster law firm’s July 22, 2011 memo discussing the D.C. Circuit’s opinion can be found here. The statement of the U.S. Chamber and the Business Roundtable about the opinion can be found here. Special thanks to the several loyal readers who sent me links about the Court’s opinion.

 

Meanwhile, Back at the FDIC: Although the standard current line on the continuing wave of bank failures is that the FDIC is winding down its bank closure efforts, the FDIC does not seem to have gotten the memo. This past Friday evening, the FDIC closed three more banks, bringing the July 2011 month to date total number of closures to 10, after the agency had closed only nine banks in the months of May and June combined. The latest closures brings the year-to-date total number of bank failures to 58, and with the latest closures signs area that the number of bank failures could continue to mount for some time to come.

 

Another thing that is striking about the YTD bank closures is how many of the closures still involve Georgia banks. So far this year, 16 Georgia banks have failed. This is after several years of massive numbers of bank failures in the state. You do start to wonder how there could be any banks left in Georgia at this point.

 

Morrison: Where is the Place of the Transaction?: As explained in the U.S. Supreme Court’s opinion in Morrison v. National Australia Bank, Section 10 of the ’34 Act and Rule 10b-5 apply  to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” The second of the two prongs in this standard requires courts to determine whether or not the disputed transaction is or is not “domestic,” which leave courts to try to determine where the transaction took place.

 

In the Quail Cruise ship case (refer here, second item), the Eleventh Circuit recently held that because the share transaction allegedly “closed” in Miami, the plaintiffs had adequately alleged that the transaction was a domestic transaction. In a more elaborate opinion, discussed here, Southern District of New York Judge Barbara Jones held in the SEC enforcement action against Goldman Sachs associate Fabrice Toure that the place of the transaction is to be determined based on the place where the transaction counterparties incurred “irrevocable liability” to take or sell the securities in question.

 

As discussed in Nate Raymond’s July 21, 2011 Am Law Litigation Daily article (here), last Thursday, Judge Jones quoted her own prior opinion in holding that the plaintiff in the civil action against Goldman Sachs in connection with the infamous Timberwolf CDO (to which an unfortunate Goldman associate referred in an email as “one shitty deal”)  had not adequately alleged that the security sale involved a domestic transaction. A copy of Judge Jones’ opinion can be found here.

 

In holding that the plaintiffs had not adequately alleged that the transaction in question took place in the U.S., Judge Jones said that in order to meet the requirements of Morrison’s second prong and establish that a transaction took place in the U.S., the plaintiff “must allege that the parties incurred irrevocable liability to purchase or sell the security in the United States.” Judge Jones dismissed the plaintiff’s complaint but with leave to attempt to replead the transactional allegations in order to establish that their transaction was cognizable under the federal securities laws.

 

Through sheer repetition, Judge Jones’s “irrevocable liability” test may become the de facto standard for determining whether or not a transaction has taken place in the United States.  On the other hand, the Eleventh Circuit’s recent (albeit somewhat unexplained) pronouncement that the place of the transaction closing is sufficient may present an alternative test on which parties may seek to rely. 

 

Choice of Law: In a prior post, I noted that choice of law may be one of the sleeper issues for determining insurance coverage. I specifically discussed the potential merits of the incorporation of a choice of law clause within the D&O insurance policy.

 

In a July 20, 2011 post on the Delaware Business Litigation Report blog, Edward M. McNally of the Morris James law firm takes a look at the question of choice of law in the context of breach of contract disputes, and he reviews the advantages of the incorporation into business contracts of choice of law provisions. His article specifically raises the questions that can arise in the D&O insurance context in the absence of a choice of law provision in the policy.

 

The Plot Thickens: When discussing the allegations many Chinese companies are raising that the assertions of accounting impropriety against the companies are the product of the fevered and self-interested imaginings of short sellers, I compared the situation to the Spy vs. Spy feature in  Mad Magazine. It turns out that I had no idea of how much skullduggery might be involved.

 

In a July 22, 2011 Thomson Reuters News & Insight article (here), Alison Frankel details the allegations and counter allegations that are flying in connection with online securities analyst and short-seller Muddy Waters, which has been at the center of a number of the assertions of financial impropriety involving Chinese companies. Apparently an anonymous online source has posted phony content purporting to show that Muddy Waters was the target of an SEC enforcement action for fraud and was forced to pay over $240 million for improper profits on stock manipulation. Another individual (who called himself “Shaun Coffey” in possible reference to famous former plaintiffs’ securities attorney Sean Coffey) is out trying to present himself as a Muddy Waters employee and attempting to use threats to try to blackmail Chinese companies.

 

Meanwhile, the July 24, 2011 New York Times had an article entitled "China to Wall Street: The Side-Door Shuffle" (here) that tells the story of how Rino International, a Chinese company, obtained its U.S. listing through a reverse merger. The article also describes how a research report from the Muddy Waters firm first raised questions about the company, following which the company's share price collapsed and lawsuits ensued. You can certainly see how there might be some people who don't like the Muddy Waters firm.

 

I will say that since she moved over to Thomson Reuters, Frankel has consistently been cranking out top quality articles and at an impressive rate. I marvel both at how she continues to come up with interesting story topics and how she cranks out an astonishing number of interesting and entertaining articles. Alison, everyone here at The D&O Diary salutes you.

 

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Largely due to last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already underway have transformed the relations between corporate boards and corporate shareholders. Even further changes loom. In a July 2011 article entitled “Corporate Governance Perspective: Current Bearings, Future Directions”  in the latest issue of InSights (here),  I  take a look at where we are now with respect to the current round of corporate governance reforms , what lies ahead, and what it all means.

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Largely (although not exclusively) driven by last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. Even further changes lie ahead. In this post, I take a look at where we are now, what lies ahead, and what it all means.

 

Many of the observations in this post were influenced by the commentary during a panel discussion in which I participated on May 11, 2011, entitled “Dodd-Frank and the Rising Tide of Shareholder Empowerment”,” at the Menlo Park offices of the Orrick law firm. The views expressed in this post are my own.

 

Changes Already Underway

Though many of the rulemakings required by the Dodd Frank Act have fallen behind schedule, a number of the implementing rules already are in place and are already driving changes. In addition, other processes not directly connected to Dodd-Frank are also underway and changing board processes, practices and structure. Here are four specific governance reform processes currently underway:

 

1. Say on Pay: As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies have had to put their executive compensation practices to an advisory shareholder vote during the current proxy season. The practice of an advisory vote on executive compensation has been in place in many European counties for some time. Many U.S. companies and their advisors resisted the adoption of the requirement here, and others questioned the value of a mere advisory vote.

 

In ways that I think may have caught some observers by surprise, it appears that – even though the shareholder “say on pay” vote is purely advisory – the implementation of the requirement for a “say on pay” vote is having a significant impact on executive compensation practices. As reflected in a May 2, 2011 Wall Street Journal article entitled “Firms Feel ‘Say on Pay’ Effect” (here) , many companies, scrambling to win shareholder approval in the say on pay vote, have been pressured to alter pay practices. As the article says, “despite some early skepticism, the prospect of such votes has sparked boardroom debate over executive-pay practices that were long-rubber stamped:”

 

The last minute changes that some corporations have put through to avoid negative votes have included some extraordinary steps. Just before the shareholder vote at Disney, for example, the company dropped certain provisions in its contract with its CEO Robert Iger, as well as other executives removing a provision that would have grossed up any compensation awards to these officials in the event of an ownership change.

 

The net effect of this process, and board’s desire to avoid a negative vote, is that certain compensation practices may fall by the wayside and all companies will face greater pressure to better align executive compensation and company performance.

 

A May 3, 2011 memo from the Davis Polk law firm (here) provides a detailed status update on the current round of “say on pay” votes.

 

2. Proxy Access: On August 25, 2010, the SEC adopted rules, in changes that were to be effective November 15, 2010, to require all but the smallest public companies to include in the proxy materials that board candidates nominated by shareholders who meet certain qualifying criteria. In order to qualify to nominate a candidate, a shareholder or shareholder group must individually or collectively own at three percent of the voting power of company’s shares and must have held those shares for at least three years.  

 

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules that the SEC had adopted. The petitioners contend that the new rules are “arbitrary and capricious,” violate the Administrative Procedures Act, and infringe on the First and Fifth Amendments. In response to this legal challenge, the SEC on October 4, 2010 issued a stay of the effectiveness of the rules while the legal challenge is pending. A ruling in the legal challenge is expected later this year.

 

While the implementation of the proxy access rules are in abeyance and the outcome of the legal challenge is uncertain, the likelihood is that in the future shareholder will enjoy greater shareholder access by requiring a company to include in its proxy materials shareholder nominees to the board of directors. As two attorneys from the Saul Ewing firm wrote in an October 29, 2010 article in the Legal Intelligencer entitled “Be Prepared: Shareholder Activism is Here to Stay” (here), “whether under the rules now being considered by the court or some revision thereof, the Dodd-Frank Act, and its focus on shareholder protection and access, ensures shareholder activism is here to stay.” 

 

3. Board Declassification: One of the long-standing objectives of corporate governance reformers has been the elimination of classified or staggered boards, whereby directors were elected for three years terms ensuring that in any given year only a third of the directors are up for vote. The Dodd-Frank Act does not have anything to say directly on this issue. Nevertheless reformers, led by the Florida State Board of Administration, have succeeded in obtaining the voluntary agreement of a number of companies to the declassification of their boards, pursuant to which the companies will put their entire board to an annual vote.

 

As one recent commentator noted, “the overwhelming trend in corporate governance is toward the declassification of boards.” An April 26, 2011 press release from the Florida Board about its efforts can be found here. A May 10, 2011 commentary by Nell Minow on her Risky Business blog about the board declassification efforts can be found here.

 

4. Majority Voting: Another longstanding goal of corporate governance reformers has been the implantation of majority voting. In many U.S. public companies, director election requires only a plurality vote, so that a director candidate in an uncontested election who receives only one vote will be elected. In a majority vote model, a director in an uncontested election who fails to receive a majority of votes must offer their resignation.

 

As discussed in an April 19, 2011 Westlaw Business article entitled “Corporate Governance: Assertive Activist Investors” (here), the 2011 proxy season is the “culmination of a major drive to install majority voting standards,” and shareholders at a number of companies have voted in favor of shareholder proposals calling for majority voting standards.

 

Changes Just Ahead

1. Compensation Ratios: In one of legislation’s lesser noted provisions, Section 953(b) of the Dodd Frank Act directs the SEC to amend its executive compensation disclosure provisions to require reporting companies to disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees. Rules implanting these provisions are required to be adopted before the end of 2011.

 

As University of Denver Law Professor Jay Brown notes on his Race to the Bottom Blog (here), these disclosure requirements potentially could be “powerful.” As Professor Brown notes, the compensation ratio disclosure would shift the executive compensation dialog away from a comparison between executive compensation at different companies toward a comparison within the company itself. The provision rather obviously reflects an intuition that there is a disparity between the compensation paid to executives and the compensation to other company employees.

 

These provisions are controversial and there already is a move underway to repeal this provision.  But if the provisions become effective and reporting companies are required to disclose the compensation ratio as specified in the Dodd-Frank Act, it seems likely that what will follow is a protracted discussion around issues of compensation fairness and compensation equity, particularly as popular  notions about the appropriate ratios develop over time. Companies whose ratios suggest greater compensation disparity are likely to face added pressure on executive compensation issues.

 

2. Compensation Clawbacks: Another of Dodd-Frank’s executive compensation requirements is set out in Section 954, which requires to SEC to direct the national exchanges to impose new listing standards directing  public companies to implement compensation clawback provisions. Under Section 954, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. According to a May 12, 2011 CFO.com article about the provisions (here), the SEC plans to propose and adopt rules implanting these requirements between August of this year and year-end.

 

The Dodd-Frank clawback provisions go far beyond the clawback requirements instituted in the Sarbanes Oxley Act. The SOX provisions were limited just to the CEO and CFO, where as the Dodd-Frank provisions are applicable current and former executive officer. SOX clawed back only the year prior to the restatement, whereas the Dodd Frank provisions reach back three years, and are applicable without regard to fault or wrongdoing.

 

The clawback provisions also have proven controversial. The CFO.com article cited above notes that these provisions have a “potentially far-reaching impact” that may “result in serious reconsideration of how incentive compensation plans are designed.” It is also possible, as another set of commentators has noted, that companies who in future find that they must restate prior financials may face litigation (or rather their officers and directors may face litigation) on questions whether a compensation clawback is required, against whom it should be enforced, and for what types or amounts of incentive compensation.

 

What it All Means

Though rule-making delays and litigation have delayed the implantation of some of the Dodd-Frank Act’s  requirements, many of the changes Dodd-Frank required are already here and others are just around the corner. These changes, and the other corporate governance reforms being pursued by shareholder advocates  have a number of significant implications, beyond just the most obvious practical effects.

 

1. Heightened Scrutiny: Not all companies are going to give in on executive compensation issues or on board process issues like board declassification and majority voting. (Indeed, there are certainly a number of serious commentators who question the value or even the wisdom of many of these reforms). But while different companies may respond to these developments in different ways, companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media.

 

A very recent example of this kind of scrutiny involves the Internet media company, LinkedIn, which has recently filed to conduct an initial public offering of its securities. In two interesting but highly critical commentaries on the DealBook blog (refer here and here),University of Connecticut Law Professor Steven Davidoff takes LinkedIn to task for adopting “a governance structure that not only disenfranchises its future shareholders, but contains elements that have been heavily criticized by corporate governance advocates.” Among other things, Davidoff criticizes Linked In for its dual share class structure that ensures that the company founders will retain voting control of the company; for adopting a staggered board; and for instituting onerous by law provisions.

 

In referencing Davidoff’s critique of LinkedIn here, I am expressing no opinions in whether or not his criticisms are valid or whether LinkedIn fairly may be criticized. Rather I cite his analysis to show the kind of scrutiny all companies are likely to face if they pursue practices or implement policies that fly in the face of the current trends in corporate governance reform. This level of scrutiny is only likely to increase as other reforms, such as the compensation ratio disclosure requirements, go into effect.

 

2. Increased Litigation Risk: Companies that resist shareholder driven reform initiatives may not only face scrutiny, but they (or their directors and officers) may also face an increased likelihood of litigation. In a recent post (here), I noted the apparent trend in which companies who experience a negative “say on pay” vote may find themselves facing shareholder litigation relating to the companies’ compensation practices. As noted above, there are others of these current reforms – for example, the clawback provisions – that could also encourage shareholder litigation.

 

3. Changing Judicial Attitudes: A very strong principal traditionally informing judicial scrutiny of board processes and decision making has been a broad judicial deference to the boards themselves. With the shift towards greater shareholder empowerment, courts may also be less inclined than perhaps they were in the past to defer to boards.

 

This notion that evolving  corporate governance norms may affect judicial consideration of board process and functioning was highlighted in the Chancellor Chandler’s August 9, 2005 opinion in the Walt Disney Shareholder Litigation, where Chandler observed that “in this era of Enron and WorldCom debacles, and the resulting legislative focus on corporate governance, it is perhaps worth pointing out that the actions (and the failures to act) of the Disney board that gave rise to this lawsuit took place ten years ago, and that applying 21st century notions of best practices in analyzing whether those decisions were actionable would be misplaced.”

 

The Chancellor’s unmistakable implication is that heightened 21st century standards will be applied to 21st century board actions – in other words, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.

 

Conclusion

There is of course within all of this extensive room for serious debate about whether or not these changes ultimately will advance or impede corporate performance and what impact all of this will have on the relatively competitiveness of U.S companies in a global marketplace. But whatever may be said along those lines, it seems clear that the changes brought about in the current round of corporate governance reforms are here to stay and will require corporate officials to adapt to the new environment.

 

Meanwhile, In Another Universe: Things that are commonplace now (the Internet, arthroscopic surgery, the E-Z pass toll collection system, open-on-the-bottom condiment containers, etc.) were virtually inconceivable just a short time ago. Rivka Galchen’s article entitled “Dream Machine” in the May 2, 2011 issue of the New Yorker provides a fascinating glimpse of even more fantastic changes the future may bring, in the form of "quantum computing" -- that is, computing based on the principles of quantum mechanics.

 

The promise of quantum computing is the vast improvement in computational power it could provide. As an example of a problem not otherwise resolvable through conventional computing but that could be solved through quantum computing is “prime factorization.” That is, it is easy to multiply two large prime numbers but very difficult to take a large number that is the product of two primes and to deduce the original prime factors. To factor a number of two hundred digits would take a conventional computer longer than the history of the universe but would only take a prime computer an afternoon.  

 

The explanation of how a quantum computer would accomplish this involves a scientific theory known as the Many Worlds Interpretation. It entails the “counterintuitive reasoning” that “every time there is more than one possible outcome, all of them occur.” So if a radioactive atom might decay and it might not, it both does and doesn’t.  From this, the many implied small branchings “ripple out until everything that is possible in fact is.”

 

According to Oxford physicist David Deutsch, the Many Worlds theory explains how quantum computers might work. According to Deutsch, a quantum computer would be “the first technology that allows useful tasks to be performed in collaboration between parallel universes.” The quantum computer’s processing power “would come from a kind of outsourcing of work, in which calculations literally take place in other universes.”

 

The Many Worlds theory to which Deutch refers to explain quantum computing’s theoretical operation seems (to me at least) to have more to do with the imaginative world of literature than it does to science. Perhaps my feeling in this respect is due in part to the unmistakable parallels between the Many Worlds theory and a short story written by the Argentine writer, Jorge Luis Borges.

 

Borges’s story, The Garden of Forking Paths, involves Dr. Yu Tsun, who is a descendant of a scholar (Ts'ui Pên ) who wrote an indecipherable novel about labyrinths. In this story, Dr. Yu meets a British sinologist who has uncovered the mystery of Ts'ui Pên’s novel. The British sinologist described his interpretation of the novel as follows:  

 

In all fictional works, each time a man is confronted with several alternatives, he chooses one and eliminates the others; in the fiction of Ts'ui Pên, he chooses-- simultaneously--all of them. He creates, in this way, diverse futures, diverse times which themselves also proliferate and fork. Here, then, is the explanation of the novel's contradictions. Fang, let us say, has a secret; a stranger calls at his door; Fang resolves to kill him. Naturally, there are several possible outcomes: Fang can kill the intruder, the intruder can kill Fang, they both can escape, they both can die, and so forth. In the work of Ts'ui Pên, all possible outcomes occur; each one is the point of departure for other forkings. Sometimes, the paths of this labyrinth converge: for example, you arrive at this house, but in one of the possible pasts you are my enemy, in another, my friend.

 

And so, I will leave you with this thought: In at least one universe, the quantum computer will become a working reality. The question that remains to be seen is which universe. Or to put it another way -- the possibility that there might be another universe in which the airline does not lose my luggage does not do me much good in the universe in which my luggage has been lost.

 

 

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Berkshire Hathaway’s Audit Committee has determined that David Sokol’s trades in Lubrizol shares prior to Berkshire’s announced acquisition of the company “violated company policies.” It also determined that his “misleadingly incomplete disclosures” to Berkshire management “violated the duty of candor he owed the Company.”  The Audit Committee reported these findings in an April 26 report to the Berkshire board, which released on its website on April 27, 2011. The report and accompanying press release can be found here. (Full disclosure: I own BRK shares.)

 

The report is the product of three Audit Committee meetings on April 6, 21 and 16, as well as a meeting of the full board in late March, and communications between the audit committee chair and company management and company counsel. In other words, while the rabble rousers outside the company were raising a ruckus about Sokol’s trades, the Audit Committee was conducting its own investigation. And it is pretty clear that as a result of this investigation, the Audit Committee is, in the words of UCLA Law Professor Stephen Bainbridge, “throwing Sokol to the wolves.”

 

The report specifically concludes that Sokol’s trading activity and his statements to Berkshire management about his trading violated the company’s Code of Business Conduct and Ethics and its Insider Trading Policies and Procedures. It also found that his conduct violated the company’s standards as articulated by its Chairman, Warren Buffett, to “zealously guard Berkshire’s reputation.” It also concluded that Sokol violated his duty of full disclosure to the Company.

 

The report specifically concludes that by trading in the Lubrizol shares, Sokol had misappropriated an opportunity that was Berkshire’s and that Sokol was only able to exploit by virtue of his position acting as Berkshire’s representative in connection with the negotiations and the transaction.

 

The report points out that Sokol’s voluntary resignation “had the effect of preventing him from receiving any severance-related benefit substantially different from those to which he would have been entitled if he were terminated for cause on the same effective date. He has thus suffered a sever consequence from his violations of Company policy.”

 

Nevertheless, the report concludes, the board is considering “possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and … whether the Company is obligated to advance Mr. Sokol’s legal fees associated with proceedings in which he is named.”

 

Finally, the company’s press release notes that it will post on its website a “complete transcript” of any questions or answers related to David Sokol at the upcoming April 30 meeting of Berkshire’s shareholders. (There might be a question or two on the topic…)

 

Among other things that the Audit Committee’s report does is that it makes it difficult for the plaintiff in the recently filed derivative action relating to these matters to be able to contend that a demand to the Berkshire board to take up this claim would have been futile. The board and its Audit Committee are quite capable of taking up these questions, thank you very much. (Among other reasons the plaintiff cited in support of his demand futilty allegatoin is that the company lacks "traditional corporate infrastructure" -- that contention look particularly wrongfooted in light of the Audit Committe's report).

 

The report’s final note about the board’s consideration of whether or not the company must advance Sokol’s legal fees is an interesting one to me. Buffett has been very public about the fact that Berkshire does not buy D&O insurance. In his most recent letter to shareholders, Buffett said, by way of explanation of why the company does not buy D&O insurance, “If they mess up with your money, they will lose their money as well.”

 

So if the company withholds defense expense advancement from Sokol, his choices are to defend himself out of his own pocket or to try to sue the company to enforce its advancement obligations. Neither is a particularly attractive choice for Sokol, as it will either cost him a fortune or put him in the very unattractive position of suing his former company.

 

I know the audit committee’s report does not include Sokol’s side of the story. (The report does not state specifically whether or not the audit committee interviewed Sokol in connection with its investigation and report). He likely has a different perspective on these events. But it seems to me that Sokol could go along way toward rehabilitating himself and his public reputation by offering to pay Berkshire trading profits he made for the Lubrizol trades and by offering  to reimburse the company for its legal expenses in investigating the trades. Any other path means more expense for the company and for Sokol and merely increases the amount that Sokol might have to pay to extricate himself from this situation later on. It just seems to me that this situation is unlikely to get better for Sokol, it will only get worse, and it won’t help Berkshire either.  

 

Lost among all this hoopla is that the Lubrizol transaction still has not closed and indeed the Lubrizol shareholders have not yet had their vote -- the Lubrizol shareholder vote  is set for June 9, 2011. Lubrizol is located outside Cleveland, and I can tell you that here in Cleveland , no one is talking about Sokol’s trades. Rather, they are talking about the $97 million that Lubrizol CEO James Hambrick stands to reap if the deal goes through. Indeed, the lead article on the front page of the April 26, 2011 Cleveland Plain Dealer was captioned “Lubrizol CEO Poised to Soar on Fabulous Golden Parachute.”  (Fulll disclosure: I have met Hambrick socially here in Cleveland.)

 

I guess a lot of questions are being asked about who will be making how much as a result of this transaction. Somewhere amidst all these issues is the larger question of whether or not the transaction itself is in the interests of the shareholders of both companies. Of course, shareholders might feel more comfortable about their interests if individuals involved in the transaction were not profiting individually from the deal.

 

Speakers' Corner: On May 11, 2011, I will be moderting a session in Menlo Park, California entitled "Dodd-Frank and the Rise of Shareholder Empowerment." The session is sponsored by the Orrick law firm, The Directors Network and Deloitte, and will take at place at the Orrick law firm's Menlo Park offices. The program, which is free and which will run from 8:45 am to 11:45 am, will provide insights and practical advice regarding fundamental changes in the corporate governance environment and the emerging role of shareholders in the U.S. corporation.

 

The session includes an all-star cast of panelists, including Roel Campos, who served as an SEC Commissioner from 2002-2007; Consuelo Hitchcock, Principal, Regulatory and Public Policy at Deloitte; Marc Gross, of the Pomerantz, Haudek, Grossman & Gross law firm; Anne Sheehan, Director of Corporate Governance at CalSTRS; Marc  Schneider, Associate General Counsel at SEIU; George Paulin, the President of George Cook & Co.; and Jonathan Ocker and Bob Varian of the Orrick law firm.

 

Furher information about the program, including regiistration information, can be found here.

 

 

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Accompanying the various print media stories this past week about the latest judicial developments involving jailed former Tyco CEO Dennis Kozlowski was the iconic photo of Kozlowski draping his arms over the shoulders of a couple of beauties at his wife’s infamous $2 million birthday bash on Sardinia.

 

There’s something about this photo that captures the ego-centric excessive essence of the era of corporate scandals. Maybe it’s the look of self-impressed arrogance on Koslowski’s face. It certainly is no surprise that the pictures and videos from the birthday party were a featured part of Kozlowski’s criminal trial.

 

The reproduction of the picture in connection with last week’s story highlights the fact that if you happen to have your arms around a couple of babes at a $2 million birthday bash on Sardinia paid for by persons to whom you owe a fiduciary duty, it is a really bad idea to allow pictures. (In fairness, at his criminal trial Kozlowski argued that the company paid only half of the cost of the event, which ostensibly also had some business-related purposes.)

 

The universality of this "no pictures" principle suggested to me that it might be worthwhile to assemble in one place all of the lessons that may be derived from the various corporate scandals over the years.

 

First, there is what I will call the Fabulous Fab Rule, which is that it is a really bad idea to write emails so provocative that they wind up reproduced above the fold on the front page of the Wall Street Journal.

 

Second, there’s the the Gen Re Executives Rule, which is that it is a good idea, if you discussing by telephone a transaction to recharacterize a public company’s reported financial results, to remember that all telephone calls at your Irish trading desk are recorded.

 

Third, there is the Smartest Guys in the Room Rule, which is that if an analyst is asking a probing question that targets sensitive issues (like the fact that Enron released its financial results without a cash flow statement or a balance sheet), it is a bad idea allowing yourself to be recorded referring to the analyst as an "asshole." (Actually, Skilling’s statement was "Well, thank you very much, we appreciate that …asshole.")

 

There undoubtedly are many other similar rules in the same vein that might be added to this list, and I encourage readers that have additional thought along these lines to add them to the list using this blog’s comment feature.

 

The Faithless Servant: The news stories this past week about Kozlowski related to the December 1, 2010 order by Southern District of New York Judge Thomas Griesa in the lawsuit Tyco filed against Kozlowski about the approximately $100 million of compensation that Kozlowski claims the company owes him under certain deferred compensation agreements. Tyco contended that the agreements were fraudulently induced or that the benefits were otherwise forfeit under New York’s "faithless service doctrine."

 

Based on the jury findings in the criminal trial, Judge Griesa concluded that under the faithless servant doctrine, Kozlowski must forfeit compensation and benefits earned during his period of disloyalty. Judge Griesa also concluded that various agreements entered during the period of Kozlowski’s disloyalty were fraudulently induced.

 

However, Judge Griesa also held that Kozlowski was entitled to trial on the question of his entitlement to benefits earned prior to the time at which the jury determined his disloyalty began. He also concluded that Tyco was not entitled to summary judgement on the company’s claim for contribution for legal expense incurred in defending lawsuits arising from Kozlowski’s breach of fiduciary duty.

 

The December 3, 2010 Wall Street Journal article about Judge Griesa’s ruling can be found here.

 

O.K., We Missed the Bridge Implosion, But You Don’t Get to See an Angry Troll Everyday: This video has quickly gone viral. From the WGN Morning News, here’s live local television in all of its glory:

　

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Though it quickly recovered, Bank of America’s share price declined earlier this week on speculation that the company is the bank whose internal documents WikiLeaks intends to post on the Internet at some future date. According to news reports, the WikiLeaks  founder Julian Assange has asserted that he has five gigabytes of Bank of America documents, which translates to roughly 600,000 pages of information. Assange has asserted that the documents to be disclosed contain highly damaging information.

 

Assange is a master of bombastic overstatement (as well as a world champion self-promoter). But let’s assume for the sake of discussion the documents are as revealing as Assange has tried to suggest and also assume that the documents do relate to Bank of America.

 

The WikiLeaks disclosure of internal company information potentially could have a couple of immediate litigation related impacts. First, to the extent relevant, the documents could affect the vast of amount of litigation that is pending against Bank of America as a result of the company’s takeover of Merrill Lynch or relating to other business activity before and during the financial crisis. It is entirely possible the revelations could aid the plaintiffs in these various cases.

 

On the other hand, and to the extent the documents relate to events or activities about which there has previously been no prior company disclosure, the WikiLeaks disclosure potentially could lead to entirely new litigation unrelated to existing cases. Were that to occur, the lawyers for the prospective plaintiffs’ complaint drafting would be substantially aided by the disclosures of internal company documents.

 

The potential revelation of internal company documents that were never intended for public consumption could also lead to a wide variety of other types of claims. If the company were to be harmed in some way by the ultimate revelation – say, for example, by a stock price drop or by reputational damage – shareholders might well file claims against senior company officials for failing to implement controls to prevent this kind of disclosure or for misrepresenting the quality of controls that were in place.

 

Depending on the type of information revealed, there could be other types of claimants. For example, customers, vendors or competitors about whom damaging information is revealed could well file suits seeks damages for the company’s failure to prevent the revelations.

 

It is one thing to consider these possibilities exclusively within the context of the threatened disclosure of Bank of America documents. It is something else entirely to consider the possibility that the threat of this type of guerilla disclosure of internal corporate documents represents a new and serious exposure for all companies. After all, what Assange is now threatening to do to Bank of America could be repeated against other companies by other zealots who somehow get access to internal communications.

 

At a minimum, it seems likely that companies and their senior executives may be mobilized to undertake vigorous new efforts to prevent future information leaks of this type. The problem for everyone is that, in the U.S. at least, we have proven to have a peculiar talent for overreacting to the most recent security breach. Due to this phenomenon, the unsuccessful efforts of the shoe and underwear bombers have managed to make air travel excruciatingly unpleasant. Corporate (over)reaction to the threatened WikiLeaks disclosure could lead to the imposition of information security constraints that could make daily life for corporate technology users extremely inconvenient and unpleasant.

 

But beyond the potential operational effects, the threat of this type of information disclosure event could also represent a new category of corporate executive exposure. Shareholders and others may expect company officials to prevent this type of disclosure from happening and may hold the officials accountable if information disclosures occur. Finally, persons whose interests are harmed by disclosures of internal company information could seek to hold the company and its senior executives liable of harm that might arise from this type of disclosure.

 

It is of course entirely likely that none of these things will ever come to pass. But even if the threatened WikiLeaks disclosure never happens or represents something less than threatened, these risks are still out there lurking in the realm of possibilities.

 

Put these issues down as one more damned category of things to worry about.

　

　

　

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NYSE Commission on Corporate Governance: On September 23, 2010, the NYSE Commission on Corporate Governance issued a report (here) following a two year review of governance issues and considerations. The Commission, chaired by Larry Sonsini of the Wilson Sonsini law firm, included more than two dozen members representing a broad range of constituencies, and its report presents an interesting and thoughtful review of the issues and statement of principles. The NYSE’s September 23, 2010 press release concerning the report can be found here.

 

The report’s centerpiece is its statement of ten principles of corporate governance, but in addition to distilling its analysis down to these ten principles, the report also helpfully reviews the history of events leading up to is report, including the recent history of corporate governance reform. In explaining its ten principles, the report states the Commission’s belief that "the respective roles of boards, management and shareholders needed greater understanding," and the principles primary focus is the respective roles of each of these three groups.

 

The board’s role, according to the report, is "to steer the corporation towards policies supporting long-term sustainable growth in shareholder value." While noting that other factors may affect long-term shareholder value, the report states (significantly in my view) that "shareholders have the right and responsibility to hold a board accountable for its performance in achieving long-term sustainable growth in shareholder value."

 

The report notes the critical role of management in establishing proper corporate governance, emphasizing that "successful governance depends heavily upon honest, competent, industrious managers." The report also noted that "constructive tension" between the board and management, if properly modulated, may be a characteristic of good corporate governance.

 

With respect to shareholders, the report takes a firm stand against short-termism. The report notes that investors have a responsibility to vote their shares in a "thoughtful manner." In a couple of different places, the report also expresses concern about the possibility of investors’ over-reliance on proxy advisory firms, noting that the decision to rely on advisory firms "does not relieve institutions from discharging their responsibility to vote constructively, thoughtfully and in alignment with the interests" of their clients.

 

The report is interesting, relatively brief and worth reading in its full length. Hat tip to the CorporateCounsel.net blog for the link to the report.

 

Norwegian Bank Files Individual Securities Suit Against Citibank: Citigroup may have settle the subprime-related enforcement action and even managed to get the court to accept the $75 million settlement (even if with certain provisos), but a separate subprime-related securities class action lawsuit on behalf of Citigroup investors remains pending. Despite the continuing existence of the class action, Norges Bank, which manages investments for the $450 billion Norwegian sovereign wealth fund, has now filed its own securities lawsuit, seeking separately to recover for the fund’s losses.

 

According to Victor Li’s September 24, 2010 Am Law Litigation Daily article (here), Norges filed a complaint in the Southern District of New York against Citigroup and 20 of its current and former directors and officers (including its current CEO, Vikram Pandit). The complaint alleges that because of the defendants’ misrepresentations about the company’s subprime exposure, Norges purchased Citi shares at inflated prices from January 2007 to January 2009. The bank claims it paid over $2 billion for the shares and claims to have lost over $835 million.

 

There are a number of interesting aspects to this case. The first is that the bank concluded that notwithstanding the existence of the shareholder class action lawsuit, its interests were better served by proceeding separately from the class. The other thing about the lawsuit is the sheer size of the claimed losses – its losses alone are far greater than the collective investor losses in most securities class action lawsuits.

 

The massive size of Norges’s claimed losses explains its desire to pursue litigation, but the initiation of a separate suit can only be explained either by Norges’s assumption that it will fare better separately than within the class, or perhaps that it will pay lower fees – or perhaps both.

 

The Norges lawsuit follows on the heals of the separate opt-out lawsuit filed against Merrill Lynch on behalf of the New York pension funds, about which I commented here. The phenomenon of large institutional investors electing to pursue their own claims was a characteristic of many of the lawsuits arising from the corporate scandals during the last decade. Though these kinds of cases had seemed to have died down for a while, the New York lawsuit against Merrill and the Norges suit suggest that the individual lawsuits may be back – and that large institutional investors may be considering them in preference to class actions.

 

The seeming rise of this phenomenon has been a matter of significant discussion and some concern, as the prospect of multiple individual lawsuits could overwhelm the putative procedural advantages and effectiveness of the class action process.

 

The magnitude of Norges Bank’s claimed losses may be sufficiently unusual to raise a question whether there may be other investors similarly motivate to pursue separate lawsuits – there simply are going to be few individual investors in few circumstance with losses of that magnitude. Of course, there is always the possibility of smaller investors with smaller losses getting into the act, which they might do if they too believe they will fare better separately rather than within the class.

 

The prospect for other investors to conclude that their interests are better served through an individual action is a prospect that could pose a host of challenges and represents a "worrisome trend," as I have previously discussed here.

 

My previous post discussing the Norwegian sovereign wealth fund can be found here.

 

More Credit Union Troubles: On September 24, 2010, the National Credit Union Administration announced a series of moves, including the seizure of three wholesale credit unions, as part of an overall effort to shore up the country’s credit union industry. The move also included the creation of a $30 billion guarantee to backstop the credit union industry in an effort to stave off further losses. The Wall Street Journal’s September 25, 2010 front page article about the NCUA’s actions can be found here.

 

Wholesale credit unions provide back office services to retail credit unions. Since March 2009, bad investments in mortgage-backed securities have resulting in the government takeover of five of the country’s 27 wholesale credit unions.

 

At least one of these wholesale credit union failures has resulted in a civil action by the NCUA against former directors and officers of the failed institution. As discussed here, on August 31, 2010, the NCUA initiated an action against former directors and officers of Western Corporate Federal Credit Union of San Dimas, California.

 

It is unclear from the NCUA’s latest announcement and actions whether the NCUA might pursue additional lawsuits against the directors and officers of other failed institutions. However, it is clear that the same kinds of difficulties that have beset the commercial banking sector are also troubling the credit union industry as well, and these troubles at a minimum additional may mean regulatory seizures and also present at least the possibility of further claims.

 

Finally, the NCUA’s moves are a reminder that two full years out from the most tumultuous moment of the credit crisis, the reverberations continue to vex the financial services industry.

 

Layoffs Mean More Job Bias and Disability Claims: According to Nathan Koppel’s September 24, 2010 Wall Street Journal article (here), layoffs arising from the economic downturn are resulting in a "rising number of claims" that companies "illegally fired workers on account of age, race, gender or medical condition." Among other things, the article cites EEOC statistics showing that for the six months ended April 30, 2010, more that 70,000 people had filed claims alleging job discrimination, which represents a 60% increase in bias claims compared to the same period a year earlier.

 

The article also notes that companies are also facing "a rising tide of disability claims," noting that more than 21,000 people filed disability claims last year, which represented a 10% increase over the prior year and a 20% increase over 2007. The article notes the difficulties financial troubled companies may face trying to accommodate disabled employees.

 

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In the opening keynote address on June 20, 2010 at the Stanford Directors’ College at Stanford Law School in Palo Alto, California, SEC Chair Mary Schapiro discussed the SEC’s "singular" mandate to address the needs of investors, noting the increasing challenges involved in "making sure the markets are fair and efficient."

 

Schapiro opened her speech discussing the ways that ways the agency is adopting its regulatory approach in light of rapidly changing technology. In particular, she addressed the events involved in and the consequences of the May 6, 2010 "flash crash" and the steps the agency is taking to "minimize chances it can ever happen again." Among other things, she steps the agency is taking to propose and implement "circuit breaker" rules to protect both the markets and investors from "clearly erroneous trades."

 

Schapiro also discussed the ways that technology has transformed trading activities, including for example the growth in ultra high speed trading activity. These developments and the increasing presence of dark pools trading, among other things, have led the agency to launch a series of initiatives, including new rules that would give the agency much faster and more complete access to information about trading activity.

 

Schapiro said that she appreciates the benefits and advantages that the various technological changes offer, particular those that "make markets more efficient, reduce costs, and increase liquidity." But, she added, "when these changes have the potential to destabilize markets without significantly contributing to key market functions, we believe they deserve a second look."

 

Schapiro then talked about the steps the agency has been taking as part of its mandate to protect the interests of "all investors, large and small." In later remarks during the Q&A, Schapiro underscored the importance to her and the agency of this aspect of the agency’s mission, noting that the SEC has to help investors, noting that "there is not another agency that works for the interests of investors."

 

Among other steps the agency is taking to try to advance its goals of helping investors is to reevaluate all existing corporate filing forms and disclosure requirements in order to consider what will be most meaningful to investors and what will "elicit better disclosure." She noted that these efforts may be slowed somewhat by the current financial reforms process and the likelihood of increased agency mandates will emerge from Congress, but the process to improve investor information will continue.

 

The final topic Schapiro addressed are the current reform initiatives, both within the agency and in Congress, with respect to corporate governance. She emphasized the SEC’s role is not to define what constitutes good governance, but rather to ensure that its requirements encourage "accountability and meaningful communication" about how the company is governed.

 

For example, the SEC’s role is not to mandate a particular board structure, but to ensure that investors know why a particular board structure was selected. She also emphasized that investors should have meaningful information about director candidates’ qualifications.

 

Among other specific governance issues Schapiro discussed were proxy disclosures and shareholder voting process issues. She enumerated a number of voting related issues that require further discussion, including, for example, the question whether proxy advisory firms should be subject to increasing SEC oversight and how to encourage retail investors voting participation.

 

Schapiro concluded by noting that while there agency faces many challenges, the "higher goal is a financial marketplace where investors invest capital in dynamic companies in a growing economy."

 

UPDATE: The text of Schapiro's speech has now been posted online, here.

 

Speakers' Corner: I am here at Stanford Law School for the conference as an interested member of the audience as well as member of the Directors’ College faculty. Tomorrow morning, I will be participating on a panel entitled "Personal Liability Risks, Indemnification and D&O Insurance." Joining me on the panel will be my good friends Priya Cherian Huskins of Woodruff Sawyer and Chris Warrior of Beazley. Though I have official responsibilities, I hope to be able to add post blog updates during the conference.

 

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Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

 

 

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

 

 

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

 

 

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

 

 

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

 

 

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

 

 

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

 

 

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

 

 

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

 

 

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

 

 

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

 

 

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

 

 

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

 

 

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

 

 

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Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

 

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

 

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

 

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

 

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

 

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

 

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

 

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

 

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

 

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

 

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

 

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

 

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities -- to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

 

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

 

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

 

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

 

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In the wake of numerous corporate scandals in recent years, many factors have been suggested as possible indicators of fraud, including outsized compensation, questionable accounting and failed oversight. But a recent paper by three Canadian academics proposes a surprising alternative indicator of fraudulent misconduct they suggest is more reliable – the size of the CEO’s ego.

 

The authors suggest that egotistical managers, stoked by media attention and analyst praise, gain a "feeling of invincibility" that leads them to "take more risks in fraudulent activities," akin to the "moths attracted to the flames that ultimately kill them."

 

In their paper, "Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Frauds" (here), Michel Magnan of Concordia University in Montreal, Denis Cormier of UQAM and Pascale Lapointe-Antunes of Brock University report on their analysis of financial reporting frauds or improprieties committed at Canadian publicly traded firms between 1995 and 2005 and that led to the imposition of penalties or fines by securities regulators.

 

At the outset, the authors observed that while the "fraud triangle" of incentives, opportunity and rationalization are "red flags" indicating possible fraud, the fact is that many companies exhibit one or more of these characteristics but very few of them are actually engaged in fraud. Because these "red flags" may not actually indicate fraud, the "red flags morph into red herrings, that may lead to numerous and unfruitful wild investigation chases."

 

The authors contend, based on their review of the 15 companies in their sample, that the missing element in the analysis is the factor that explains why some companies become involved in fraud. The missing element, they contend, is "managerial hubris", which they say "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud." The authors define "managerial hubris" as "exaggerated pride or self-confidence often resulting in retribution," deriving the meaning from the concept in Greek tragedy for "man’s fatal flaw."

 

The authors propose that:

 

Hubris actually ignites and accelerates the sequence of incentives, opportunities and attitudes (rationalization) that bring CEOs to engage in financial reporting frauds or to be oblivious to such frauds being committed in their own entourage.

 

Interestingly, the authors noted that many of the firms studied were not completely unrestricted; to the contrary, many seemed to exhibit governance mechanisms that appeared to be functioning. Thus, for example, 12 of the 15 firms had a majority of independent directors, and "at least 7 out of the 15 had ‘star’ directors who brought considerable credibility." In addition, "most of the sample firms were supposedly screened or watched by some of Canada’s leading intermediaries."

 

The authors noted that the firms "were subjected to what would appear to be appropriate oversight and scrutiny." The authors’ view is that "for fraud or impropriety to be committed, governance and markets monitoring conditions need to be present, as they provide additional cover."

 

The authors’ most striking observation is that all of the sample firms or their top executives "were the objects of glowing media, society or stock market reports," which "may have either enhanced the willingness of perpetrators of fraudulent activities to pursue their actions or removed successful CEOs from carefully monitoring their executive team." The authors observed that "hubris can be fed and magnified when there is too much self-reflection of success and achievements." This managerial hubris, stoked by the fawning attention of the media and analysts "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud."

 

The authors suggest that awareness of these factors can aid fraud detection, because this element of hubris is "more likely to be transparent" when executives are asked about "plans realizations, future strategies." The authors suggest that "inconsistencies between executives’ statements and observable facts or realities, outlandish claims, and a lack of concern for operational detail can be signals that managerial hubris has set in."

 

Thought the authors’ study is limited to Canadian companies, the authors note that "it is highly likely that managerial hubris is present in U.S. cases of fraudulent financial reporting as well" (citing the example of Scott Sullivan, the former CFO of WorldCom).

 

But while the authors refer to the possible applicability of their analysis to financial fraud in the U.S., they also acknowledge the potential limitations of their analysis as well. Among other things, they note the small size of their sample, which they acknowledge represents a "limitation" even though it also afforded them the opportunity for a more detailed study of each case.

 

The authors note that there may be factors unique to Canada at work as well. For example, they note that due to the relatively small size of Canada’s business environment and the relatively fewer number of media outlets there, "it is probably easier for someone to attain ‘star" status in Canada."

 

The authors also note that many Canadian firms have a CEO who is also a controlling shareholder or member of a control group, which may both give the CEO a stronger personal incentive to commit fraud and great opportunities to overcome internal controls. This fact may explain much about the cases the authors studied; in 13 of the 15 cases, the firm’s CEO was "an important shareholder, if not the controlling shareholder."

 

These somewhat distinctly Canadian factors may limit the extent to which the authors’ analysis may be applicable outside Canada, particularly in the U.S. where very few public companies are as controlled as were these Canadian firms. The characteristics of those Canadian firms may have given the hubristic CEOs more opportunity to indulge their egotistical goals, in ways that might not be available to many CEOs in the U.S., even to highly egotistical American CEOs.

 

Of course, there are countless examples of egotistical CEOs of U.S companies that led their companies in fraudulent misconduct –it is just that the presence of a hubristic CEO may or may not be as indicative of fraudulent misconduct in the U.S. as in Canada. Perhaps it is a topic for further study.

 

There is the problem about what to do with the authors’ conclusions, even if we accept them as valid and applicable both in Canada and outside as well. It is not as if analysts, auditors or D&O insurance underwriters can administer personality tests to measure the size of CEOs egos. And favorable press, even highly favorable press, is not always an indicator of problems looming – to the contrary, the media reports might be lavishing praise not because they are duped by fraud, but because the company’s performance actually is praiseworthy. Moreover, many CEOs have enormous egos. Arguably, only someone with a massive ego would even attempt to do their jobs.

 

In the end, the authors are suggesting only that signs of hubris should be watched for, and where found in the presence of more typical red flags, uses as a trigger for further investigation – an observation that is undeniably sound.

 

One final observation is that at some level, the authors’ research conclusions are consistent with the research I discussed in a prior blog post (here) that suggested an inverse correlation between the size of CEO’s houses and their company’s performance. Both studies suggest that if a company becomes an instrument in a CEO’s self-aggrandizement, shareholders better watch out.

 

Very special thanks to Professor Michel Magnan for providing me with a copy of the research paper. Hat tip to the Securities Docket (here), for linking to an August 26, 2009 Toronto Globe and Mail article (here) discussing the research paper.

 

And Speaking of Hubris: One of the more astonishing parts of the global financial crisis is the outsized role that banks based in Iceland played, particularly in the early stages of the crisis. The question of how several banks from a very small county in the North Atlantic created such havoc is one of the great puzzles of the crisis.

 

Picking up on the Canadian authors’ research, I would suggest that one of the ways Icelandic banks came to assume such an outsized, and ultimately dangerous role, was hubris. If you have any doubt, watch the following (pre-collapse) video from Kaupthing Bank, which, before it was seized by Iceland’s banking regulators, had transformed itself into Iceland’s largest bank. You don’t think there were some massive egos involving in this operation? (Fatal last words: "We can if we think we can... We think we can continue to grow the same way we always have.") 

 

Hat tip to Clusterstock (here) for the link to the video.

 

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A variety of news articles and blogs have expressed surprise and even outrage that Bank of America is advancing the legal expense that former Countrywide CEO Angelo Mozilo is incurring in defending against the various claims that have been raised against him, including the recent SEC enforcement action.

 

There is no particular reason for me to bestir myself to justify BofA’s action, particularly since Mozilo has done such an effective job making himself look like a cartoon villain (as I discussed here). But under Delaware law and under the legal understandings that BofA reached when it acquired Countrywide, BofA has a legal obligation to advance Mozilo’s expenses. The only outrage would be if BofA refused to do so.

 

Countrywide was a Delaware Corporation. BofA is a Delaware Corporation. Under Section 145(e) of the Delaware General Corporation Law, companies are permitted to advance expenses directors and officers incur in defending claims brought against them for actions undertaking in their capacities as directors and officers. Most companies’ by-laws make these advancement requirements mandatory, which I presume would have been the case for Countrywide. Mozilo may even have had a separate advancement and indemnification agreement; many senior executives do. In addition, as reflected in a June 9, 2009 Bloomberg article (here), the two companies’ July 1, 2008 merger agreement specified that Bank of America would maintain Countrywide’s existing indemnification rights for six years.

 

There is a very good reason for the legal formality surrounding advancement and indemnification; that is, the question of entitlement to these rights usually comes up only after serious allegations have arisen. Accordingly, it is important to lock down rights and obligations at a calmer time, so that duties and expectations are clear if questions later do arise. Having entered these agreements, companies are not at liberty to dispense with the commitments simply because they later find it distasteful or repugnant to honor the commitments.

 

Mozilo may well be one of the most unpopular figures in the United States right now, and a lot of people want to make him the poster child for everything that went wrong with our financial system. But as reviled as some might perceive him to be, that does not deprive him of his legal rights nor does it relieve BofA, as Countywide’s successor-in-interest, of its legal obligations.

 

Keep in mind that Mozilo has not been convicted of anything (yet?) – indeed, though he is one of the subjects of an SEC civil enforcement action, no criminal charges have been brought against him. Nor has he yet been found liable in any of the many civil actions against him.

 

Indeed, even if criminal charges had been brought, Mozilo would nonetheless retain the right to advancement of his defense expenses. In considering the extent of Mozilo’s rights, it is important to recall the July 30, 2008 Delaware Chancery Court opinion (here) in which Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Vice Chancellor Strine held that under Delaware statutory law and the applicable by-law provisions, requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.

 

Whatever else may be said, advancement rights are enforceable and durable. (I will leave aside the problem created by the Schoon v. Troy case, about which refer here, which did seemingly permit the retroactive elimination of advancement rights, the Delaware legislature recently created a statutory remedy for that bobble.)

 

BofA is of course entitled to obtain from Mozilo an undertaking to repay the expenses advanced if it is later determined that he did not act in "good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation." Mozilo is a very wealthy man, wealthy enough that if the statutory standard for repayment is triggered, BofA can try to recover the amount advanced – that is if there’s anything left at that point.

 

I understand that the main objection to BofA’s advancement of Mozilo’s defense expenses is that BofA has accepted $45 billion in bailout money. The objection is that taxpayers are effectively paying Mozilo’s legal fees, or something like that.

 

One might try to argue that, because taxpayers shouldn’t have to foot the bill, companies accepting bailout funds ought to be required to terminate advancement or indemnification rights of former officers and directors, but as far as I know there were no such requirements imposed in connection with the bailout money provided to BofA. Moreover, even though Congress has a pretty impressive record of trying to impose retroactive conditions on bailout recipients -- without the slightest regard for the requirements of binding contracts -- there are still some very good policy reasons why even Congress would have to hesitate to retroactively superimpose a bailout condition like that.

 

In any event, the objection about Mozilo’s defense expenses is not to advancement of defense expenses as a general matter, but to advancement for Mozilo in particular. There is no principled basis on which to isolate one individual, no matter how unpopular he may be, and single him out as the one person retroactively disentitled to his otherwise enforceable rights. To put it another way, if Mozilo is not entitled to advancement, then no current or former director or officer from an entity receiving bailout funds should be entitled to advancement. I suspect that even the most thick-skulled, grandstanding member of Congress would see the policy concerns with taking that position.

 

There is an added component to this question – that is, the extent to which Countrywide’s D&O insurance may be reimbursing BofA for its advancement of Mozilo’s defense expense. Countrywide undoubtedly carried D&O insurance, likely with limits of liability in the tens and perhaps in the hundreds of millions of dollars. The Countrywide insurance program may have had a significant self-insured retention, but that has likely been satisfied even if it is many millions of dollars.

 

The problem with D&O insurance as a source of reimbursement for defense expenses is that there are so many lawsuits against Countrywide and its directors and officers in so many different courts that the insurance limits could quickly be depleted or even exhausted, assuming for the sake of discussion that the carriers have not asserted defenses to coverage.

 

To the extent not reimbursed by insurance, BofA will have to advance Mozilo’s defense expenses. For those who still just find this too much to swallow, here’s one final thought – even if BofA is obliged to pay Mozilo’s defense expense due to an undertaking the merger documents, BofA appears to be making money from the Countrywide acquisition. According to Bloomberg (here), BofA reported mortgage-banking income in the first quarter of $3.71 billion, compared to $1.52 billion in the first quarter of 2008, "because of surging demand for home loan refinancings." This is a significant form of consolation for the fact that BofA is on the hook for Mozillo’s defense expenses.

 

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One of Congress’ goals when it instituted the "lead plaintiff" provisions of the PSLRA was to encourage institutional investors to become more involved in controlling and monitoring securities class action lawsuits. But now that institutional investors are indeed more involved in securities lawsuits, the question has become – what difference has it made? A recent academic study suggests that institutional investor involvement in securities litigation not only enhances investors’ success in seeking financial recovery, but also improves the quality of the defendant companies’ corporate governance. The authors conclude that securities litigation is an effective corporate monitoring tool for institutional investors.

 

A January 2009 paper entitled "Institutional Monitoring through Shareholder Litigation" (here), by Agnes Cheng of LSU, Henry He Huang of Prairie View A&M University, Yinghua Li of Purdue, and Gerald Lobo of University of Houston, examined all securities lawsuits that were filed from January 1, 1996 to July 20, 2005 and that had been resolved by June 1, 2006. 1,811 lawsuits met these selection criteria, of which 1,525 lawsuits were led by individual lead plaintiffs, 178 lawsuits were led by at least one public/union pension fund or mutual fund, and 108 lawsuits were led by other categories of institutions.

 

Among other things, the authors found a "trend of increasing institutional involvement in securities litigation." The percentage of lawsuits with institutional investor lead plaintiffs has more than doubled from less than 15% in 1996 to more than 30% in 2004.

 

The authors were most concerned in determining the effect of institutional investor involvement in case outcomes. Prior research had already shown (as reflected in my prior post, here) that cases with institutional investor lead plaintiffs result in larger settlements, primarily because institutional investors tend to become more involved in the larger, more serious cases.

 

In order to be able to control for the differences due to the kind of case in which institutional investors become involved, the authors identified the "determinants" that affect institutional investor involvement and used these factors as control variables. The authors identified a range of variable associated with the increased likelihood of institutional investor involvement, including merit and potential damages, size of the defendant company, and prior performance of the defendant company.

 

Among other things, the authors found that institutional investors are more likely to be involved when the case does not involve an IPO, when accounting issues are present, and when accounting firms are involved. The cases also tend to involve longer class periods, more significant investor losses and companies with higher levels of institutional shareholdings.

 

The authors used a multivariable regression analysis to control for these case differences, in order to be able to determine the impact attributable to having an institutional investor as the lead plaintiff. The authors found that after controlling for the determinants of having an institutional investor lead plaintiff, "lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements."
 

 

Specifically, the authors found that "institutional plaintiffs play a significant role in defeating the defendant firm’s motion to dismiss," finding that "an institutional lead plaintiff can reduce the dismissal probability by 38.2%" The authors found this relationship held even when tested against control variables relating to the possibility that the institutional lead plaintiffs simply selected the most meritorious cases.

 

The authors also found that the presence of an institutional lead plaintiff "can increase the total settlement amount by approximately 59.8%," when controlling for all the various factors that might be due to the type of case in which institutional investors tend to become involved. The authors concluded that "having an institutional investor lead plaintiff is associated with both a statistically and an economically larger impact on the settlement amount than having an individual lead plaintiff."

 

Finally, the authors also found that within three years of the lawsuit filing, defendant companies that faced institutional investor lead plaintiffs experienced greater improvement in board independence than those facing individual lead plaintiffs.

 

To measure this impact, the authors looked at changes in three variables within three years of the lawsuit filing: percentage of independent boar members in the full board, percentage of independent audit committee members, and whether there is a lead director. The authors found that the presence of an institutional lead plaintiff was associate with more significant reform in these three areas, from which the authors concluded that "the impact of securities class action on governance change depends on the type of lead plaintiff."

 

From these various observations, the authors conclude that "institutional investors’ involvement in securities litigation enhances not only investors’ success in seeking financial recovery, but also the quality of the defendant firms’ corporate governance." From this, the authors further conclude that "institutional investors could use litigation as a mechanism to discipline management and to secure the long-term health of the firm"

 

The authors noted the increasing incidence of institutional investors choosing to opt out of certain class settlements, which the authors note suggests that some investors may find opting out and filing individual lawsuits to be a stronger monitoring tool that leading the class action. The authors, citing recent research by Columbia Law Professor John Coffee (about which refer here), observed that "while the reasons for institutions opting out are interesting, our empirical sample limits our ability to study that issue." The questions surrounding institutional investors’ willingness to opt out raises a host of interesting issues, not the least of which is the relative importance on a continuing basis of class action litigation of a monitoring tool along the lines the authors suggest. The authors note that this is an interesting question for another day.

 

One final observation about the authors’ interesting study is that their article, like an increasing amount of legal literature, depends on the application of sophisticated mathematical tools to problems arising in the legal context. While this approach unquestionably has its value, it does make for some daunting presentations and some impenetrable analyses.

 

I certainly am in no position to question (much less fully appreciate) the validity of the authors’ quantitative approach. I confess that I must simply take it on faith that the authors’ regression analyses are both suitable and properly applied. The more critical approach I generally prefer to take is simply not an option for me when it comes to considering this type of quantitative analysis. I am uncomfortable taking so much on appearances – the authors’ work certainly appears to be rigorous – but without undertaking a massive self-reeducation project, I am hardly in a position to do anything differently.

 

At least I understand and appreciate the authors’ conclusions. Like a docile and uncritical church congregation, I know when to say "Amen."

 

A post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog about the authors’ paper can be found here.

 

Inspiring Words: While reading Ronald C. White, Jr.’s literary biography of Abraham Lincoln entitled The Eloquent President (here), I had occasion to re-read Lincoln’s First Inaugural Address, including the speech’s stirring final paragraph:

 

I am loath to close. We are not enemies, but friends. We must not be enemies. Though passion may have strained it must not break our bonds of affection. The mystic chords of memory, stretching from every battlefield and patriot grave to every living heart and hearthstone all over this broad land, will yet swell the chorus of the Union, when again touched, as surely they will be, by the better angels of our nature.

 

It is easy for us now to admire the eloquence of these words at the remove of nearly a century and a half and with the luxury of time for quiet reflection, but the words are even more impressive when considered in the context of the circumstances in which they were first delivered. At the time of the inauguration, seven states had already seceded; the very next day, Lincoln would receive word from the commander of Fort Sumter that his supplies were nearly exhausted. Lincoln’s optimistic words reflect an earnest but nearly impossible hope for reconciliation at one of our nation’s darkest hours.

 

Reading Lincoln’s words filled me with the same feelings I had when listening to Winston Churchill’s "Battle of Britain" speeches while I was touring the War Cabinet Rooms in London earlier this year. Both examples underscore the powerful potential of words to illuminate and inspire, even in desperate and hopeless times.

 

One of the more interesting details about this paragraph of Lincoln’s speech is that it was the result of an unlikely collaboration between Lincoln and his Secretary of State, William Seward. As well-told in Doris Kearns Goodwin’s excellent book, Team of Rivals, Lincoln and Seward would go on to become political allies and close friends, but at the outset of Lincoln’s presidency, they were political rivals who hardly knew each other and who had never worked together. Lincoln set aside his ego and not only asked Seward to review his draft speech, but he adopted most of Seward’s suggestions.

 

The most fascinating part of this collaboration is how Lincoln adopted Seward’s suggestions. White’s book puts Seward’s suggestions and Lincoln’s final text in side by side columns, which highlights how Lincoln transformed Seward’s proposed language, sometimes in subtle, sometimes in powerful ways. For example, Seward did indeed suggest the phrase "mystic chords" but Lincoln rendered the phrase as "mystic chords of memory." Seward suggested "the guardian angel of the nation," which Lincoln changed into "the better angels of our nature." Lincoln turned Seward’s well-intentioned prose into meaningful, musical poetry, with words that still resonate and inspire.

 

The transformative power of Lincoln’s use of language was not lost on Seward; he came to appreciate the power of Lincoln’s words perhaps as much as anyone. Though Seward presumed to make six pages of suggestions to Lincoln’s First Inaugural Address, his presumptions changed as he came to know Lincoln better. Three years later, when asked if he had helped Lincoln write the Gettysburg Address, Seward said, "No one but Abraham Lincoln could have made that address."

 

One of the more remarkable things about Lincoln’s powerful use of language is that he had less than one year of formal education. For some reason, in our own time, we have restricted higher office eligibility to individuals who acquired at least a part of their higher education at one of two elite Eastern universities. Indeed, the current President and his three immediate predecessors all share this common educational connection. I am not sure why this peculiarly narrow form of educational elitism now predominates our politics, but the danger is that something vital and fundamentally American could be lost as a result.

 

One interesting note about Lincoln’s first inauguration is that Lincoln was the ninth President for whom Chief Justice Roger Taney administered the oath of office, a feat of longevity and endurance that so unlikely that is seems incomprehensible. Given our current Chief Justice’s relative youth, one can wonder whether he might eventually swear in as many Presidents as Taney. Perhaps in future inaugurations, Chief Justice Roberts will actually administer the Oath’s required words correctly, on the first try.

 

In our time, the Gettysburg Address, the Emancipation Proclamation and even Lincoln’s Second Inaugural Address may all be better remembered than the speech Lincoln delivered at his first inauguration. Lincoln’s words in his other speeches are indeed memorable. But it seems to me that in our time as throughout our history, the mystic chords of memory unite us to our past and our aspirations now more than ever and the prayerful hope for the influence of the better angels of our nature remain as strong as ever.

 

Lincoln’s words remind us that our nation’s history includes days that were darker than even those today, but even in those desperate times, we never lost hope and we did persevere — as Lincoln might have said, with God’s help.

 

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As governance ratings have become ubiquitous, they have also attracted an increasing about amount of attention, not all of it positive. As I noted in a prior post (here), one academic study questions the "predictive validity" of the governance ratings. A more recent academic study questions the applicability of uniform governance standards to disparate companies.

 

In any April 2009 paper entitled "Elusive Quest for Global Governance Standards" (here), Harvard Law Professor Lucien Bebchuk and Hebrew University of Jerusalem Professor Assaf Hamdani question whether the effort to establish uniform governance metrics suffers from a "basic shortcoming"; that is, the authors question whether certain corporate arrangements counted as good governance should be considered equally valuable for all companies.

 

In particular, the authors contend that the value of certain arrangements "depends considerably on companies’ ownership structure" and that "measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder."

 

In elaborating on this perspective, the authors note that in the U.S. most public companies lack a controlling shareholder, by contrast to companies outside the U.S. that often have a controlling shareholder. Given the absence of a controlling shareholder, "for anyone approaching governance arrangement from a U.S. perspective finds it is natural to assume that the arrangements governing control contests are a key element in the governance of public companies." This kind of bias results in a preference for governance arrangements that, for example, relate to takeovers and proxy fights. However, for companies that have controlling shareholders, "the presence of arrangements providing protection against a hostile takeover or a proxy fight is neither good nor bad, but simply irrelevant."

 

In view of these differences deriving from this important ownership distinction, certain governance practices, the authors suggest, should be weighed in assessing governance according to whether or not companies have a controlling shareholder.

 

The authors reviewed the governance rating methodology of three governance rating systems: RiskMetrics’ Corporate Governance Quotient (CGQ); and two measures developed by academics, the Anti-Self-Dealing Index and the Anti-Director-Rights Index. The authors conclude that presumptions built into the measures reflect a "failure" to "properly take into account the relationship between ownership structure and corporate governance," which "substantially undermines the indices’ ability to serve as effective metrics for the quality of the governance at firms or countries worldwide."

 

The authors are not against the development of governance metrics; as they put it, they "do not question the feasibility of developing a methodology for large-scale governance assessments." Rather they argue that commentators and practitioners should "develop separate systems – one for controlled and one for widely held firms," so that the rating methodology "fits the company’s ownership structure."

 

The authors’ analysis makes an important contribution for the understanding and use of the now ubiquitous governance measures. In particular, it may be critical for those relying on these measures to understand their limitations in certain contexts. By the same token, it is worth emphasizing that the limitations the authors cite will be most relevant in connection with companies outside the Unites States. The authors apparently do not question the general usefulness of the measures for U.S.-domiciled companies that lack a controlling shareholder (or for that matter, for any company lacking a controlling shareholder).

 

The more interesting question may be whether or not there are other limitations on the one-size-fits all approach to corporate governance measurement. I have often been concerned that governance metrics applicable to larger companies may not be as applicable to smaller companies, or that governance requirements best suited for mature companies may not be the same as those suited, say, for a developmental stage company. I have also often wondered whether the standards should be applied the same to all companies in all industries.

 

All of which to me suggests that there could be room for additional research along the lines undertaken in this study, to examine whether or not there may be other ways in which governance metrics should reflect separate methodologies for assessing different categories of companies.

 

He’s At It Again: Some readers may recall the recent post (here) in which I reported on the lawsuit that purported to be brought on behalf of Bernard Madoff by federal prison inmate Jonathan Lee Riches against Brittney Spears. As reported in a May 23, 2009 article in the Spokane Spokesman-Review (here), Riches has now filed another lawsuit in the Eastern District of Washington seeking an injunction to stop the Guinness Book of World Records from naming him as the person who has filed the most lawsuits in the history of mankind. A copy of Riches’ latest complaint can be found here.

 

Riches contends that the Guinness Book plans to print false information about him, among other things apparently by undercounting the number of lawsuits Riches claims he has filed. He also objects to the names the Guinness Book intends to call him, including "Johnny Sue-nami," "Sue-per-man," "the Patrick Ewing of Suing" and the "the Lawsuit Zeus." He says that these phrases "hurt my feelings and violates my civil rights."

 

Riches filed his case in the Eastern District of Washington despite the February 23, 2009 order (here) entered in that court by Judge Justin Quackenbush, in a case in which Riches had sued the Peanut Corporation of America claiming to have been poisoned with Salmonella-tainted peanut butter. In the order, Judge Quackenbush had admonished Riches that his "ability to file future cases in this court will be enjoined" if Riches continue to filed cases that fail to state a claim or that are "deemed frivolous or malicious."

 

Among other things, in his latest lawsuit, Riches claims that the Guinness Book has "no right to publish my work, my legal masterpieces." Riches prior lawsuit targets include among others Somali pirates, Plato, Nostradamus, George Bush and New England Patriots Coach Bill Belichick. (Riches undoubtedly filed the Belichick lawsuit to prove that not all of his lawsuits are frivolous.) In his latest complaint, Riches says he has also sued Black History Month, the president of Iran and butter substitute "I Can’t Believe It’s Not Butter!"

 

Riches also asserts that "when I get out of prison, I’m going to start a Lawsuit 101 shop and teach Americans how to file pro se lawsuits." He also said "I will sell Jonathan Lee Riches T-shirts" saying "Watch out what you do, or I’ll sue you."

 

Hat tip to the Overlawyered blog (here) for the link to the Spokane Spokesman-Record article.

 

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A growing chorus of voices is calling for public companies to make the separation of the Chairman and CEO functions the default governance structure. This movement, which may have the support of the new SEC Chair, appears likely to lead to some type of "adapt or explain" approach. Increasing evidence that the companies where the CEOs also act as board Chair are likelier to have "certain troubling governance characteristics" will likely encourage shareholder interest in the initiative as well.

 

The idea of separating the two roles is hardly new, but it has gained significant support from a wide variety of sources recently. First, on March 30, 2009, the Chairmen’s Forum of the Millstein Center for Corporate Governance at Yale School of Management issued a report entitled "Chairing the Board: The Case for Independent Leadership in Corporate North American" (here) calling on all North American companies to "voluntarily adopt independent chairmanship as the default model of board leadership," and if they chose to take a different course "to explain to their corporate shareholders why doing so represents a superior approach to optimizing long-term shareholder value."

 

(The Chairman’s Forum is a group of more than 50 current and former board chairs, directors and CEOs convened at the Millstein Center.)

 

The Millstein Center’s March 30, 2009 press release (here) reports that while in the U.k. only 5% of the FTSE 350 companies combine the chairman and CEO roles, over 60% of the S&P 500 companies have boards that are chaired by their CEOs. The press release quotes one commentator as saying that the independent chair model "has been adopted successfully by many companies in many regions of the globe as a means to further ensure and empower board independence."

 

The press release also quote the former chairman of Northwest Airlines as saying that combining both roles puts both functions in one person who "is obviously conflicted in the essential duty of providing oversight and monitoring the CEO and management team."

 

A March 30, 2009 Wall Street Journal article discussing the Chairmen’s Forum’s report can be found here.

 

Recent remarks from, Mary Schapiro, the SEC’s new Chair, in her April 6, 2009 speech to the Council of Institutional Investors (here), seem to suggest the possibility of an SEC move to a disclosure based approach toward separating the two roles. Among other things, she said that "we’ll also be considering whether boards should disclose to shareholders their reasons for choosing their particular leadership structure—whether that structure includes an independent chair, a non-independent, or a combined CEO/Chair."

 

As Professor Jay Brown has suggested on his Race to the Bottom blog (here), Schapiro’s remarks may suggest a SEC attempt to influence corporate governance through disclosure. Professor Brown has been a vocal advocate in favor of separating the two roles (as shown here).

 

The logic of targeting this particular issue as an important corporate governance objective was reinforced by the research recently released by The Corporate Library. As described in their March 25, 2009 press release (here), companies whose CEOs also serve as board Chair are "more likely to have certain troubling corporate governance characteristics than companies where the roles are separated."

 

The troubling characteristics, which are "associated with board entrenchment or lessened oversight of management," include relatively long CEO tenures; fewer board meetings per year; classified board structure; and "the presence of executive committees, which are typically given the power to act on behalf of the entire board, potentially allowing for a concentration of power."

 

The Corporate Library’s findings raise the possibility that having a single person as the Chair and CEO could be a risk factor for D&O insurance underwriters to assess. Along those lines, it is worth considering, as noted by the Chairmen’s Forum report, that "the overwhelming majority of financial institutions had combined roles before the current crisis erupted" – including, among others, Bear Stearns, Lehman Brothers, Citigroup, Washington Mutual and Wachovia.

 

On the other hand, there may be limits to how much can be expected or discerned from this single governance trait. As the Chairmen’s Forum’s report also notes, "splitting the role of chairman and CEO does not guarantee the application of independent oversight," adding that "it is no secret that certain companies, featured in some of the most famous corporate debacles, had separate CEOs and chairmen." Splitting the roles must be accompanied by other steps "in order for the independent chairman to fulfill the important leadership role."

 

In other words, while the continued combination of the two roles in a single person may (particularly in the current climate) represent something of a risk factor, the separation of the two functions alone is no guarantee of the absence of risk.

 

In any event, it seems likely that pressure for change will continue for all companies, and that companies that do not change will find themselves increasingly called upon to explain.

 

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Litigation over executive compensation is nothing new. The long-running clash over Richard Grasso’s $187 million NYSE pay package is only one of many titanic legal battles compensation issues produced in the past. But executive compensation litigation recently seems to have entered a new phase, fueled by moral outrage.

 

Drawing on popular anger evidenced most recently in the outrage surrounding the AIG bonuses, these most recent compensation-related cases could represent an even more pronounced litigation threat than prior lawsuits over pay. The same forces driving the litigation have also produced a variety of other corporate and social responses, some of which may or may not fully serve the purposes of overall social utility.

 

Among other recently filed lawsuits involving executive compensation is the derivative complaint filed on April 1, 2009 in California (Los Angeles County) Superior Court against the current AIG CEO Edward Liddy and several other AIG directors and officers. The complaint (copy here) among other things alleges that "there was no rational business purpose or justification for these lucrative additional payments, particularly given AIG’s deteriorating financial condition and dismal financial performance," and described Liddy’s explanation of the bonus payments as "outrageous on its face" and "absurd." The complaint seeks to recover damages for corporate waste, breach of fiduciary duty, abuse of control and unjust enrichment.

 

The bonuses paid to Merrill Lynch employees at year end just prior to the consummation of the company’s merger with Bank of America also features prominently in the shareholders’ litigation filed against Bank of America earlier this year, following the revelation of Merrill’s massive and previously unreported losses.

 

The $68 million exit package awarded Citigroup CEO Charles Prince following his November 2007 departure from the company is the subject of one of the claims in a Delaware shareholders’ derivative suit against Citigroup’s board. The claim, which alleges waste, is particularly noteworthy, because in a February 24, 2009 decision (here) in which the Delaware Chancery Court otherwise dismissed the plaintiffs’ claims against the Citigroup board for failure to monitor the company, the court found that the claim related to Prince’s compensation had been adequately pled. Unlike plaintiffs other claims, the claim for waste survived the motion to dismiss. An April 2009 memo entitled "Executive Compensation Under Fire" (here) from the Greenberg Traurig law firm described the denial of the motion to dismiss in the Citigroup case on the waste issue as "an unusual move from the traditionally pro-business courts."

 

As noted on the CorporateCounsel.net blog (here), the Delaware Court’s ruling in the Citigroup case regarding the compensation claims could be the most significant part of the decision and could suggest a possible judicial receptivity to waste claims related to executive compensation. The Greenberg Traurig memo cited above comments that as a result of this decision, "don't be surprised if more companies face similar challenges to executive compensation in the future," adding that these challenges might include not only a derivative suit like the one involving Citigroup, but also shareholder demands on the board; books and records requests; and even proxy contests.

 

An April 6, 2009 Law.com article entitled "Executive Bonuses Triggering Lawsuits Nationwide" (here) observes that litigation triggered by executive compensation controversies not only include claims of excess compensation but also lawsuits ranging "from corporate officers who allege their companies reneged on bonuses to officers who believe they were fired for protesting them." The article, which cites several examples of each of these kinds of claims, also notes that "attorneys are bracing for more litigation and legislation involving executive bonuses and compensation matters."

 

In addition, another recurring theme currently surrounding executive compensation is the possibility of a clawback remedy, to recover compensation already paid, which is a topic I previously discussed here.

 

One positive consequence of the current furor over executive compensation is that at least some companies have become more solicitous of shareholders’ views on pay. Indeed, as discussed in an April 6, 2009 Wall Street Journal article entitled "Companies Seek Shareholder Input on Pay Practices" (here) reports that biotech firm Amgen invites its shareholders to complete a 10-question online survey to determine the shareholders’ views on whether the company’s compensation plan is based on performance and whether performance goals are clearly disclosed and understandable. The article identified other companies that are taking similar steps to consult or enlist shareholders.

 

That said, the actions taken based on current popular outrage over executive compensation issues also have an ugly side. The stones thrown through the home windows of former RBS chairman Fred Goodwin and the French workers’ recent seizures of local managers, among other recent examples, suggest the possibility that the current populist backlash could slip into far more dangerous manifestations, which is one of the dangers when politicians play to the galleries on these kinds of issues.

 

Popular anger over bonuses paid to money-losing managers is understandable. Indeed Goldman Sachs Chairman and CEO Lloyd Blankfein has said (here) that he recognizes why the public is angry and called for a reform of the way financial institution executives are compensated, particularly at companies receiving government bailout funds.

 

All the same, we should take care as a society that our proclivity for blamecasting and scapegoating does not unleash darker forces. Social disorder has arisen in past economic crises, and there is nothing that says that it can’t happen again.

 

An April 7, 2009 Wall Street Journal op-ed column considers (here) how generalized populist outrage can quickly transform into nationalist or ethnic rage.

 

My apologies to The Economist  for using the cover art from this week's issue of the magazine to lead this post. I figure that on the cover of last week's issue of the magazine, they shamelessly imitated the iconic Saul Steinberg Map of New York cover art from the March 29, 1976 issue of The New Yorker Magazine. In its original form, Steinberg's map reflected a view of the world as seen from New York's Ninth Avenue. On the cover of last week's issue, The Economist adapted Steinberg's map as a contemporary map of Beijing, adding an apology for the adaptation. I extend to The Econmist the same apology here for my adaptation of the magazine's cover art here.

 

Subprime Securities Litigation: Early Trends: Even though the subprime and credit crisis-related litigation wave recently entered its third year (as I noted here), and though there have been a few settlements as well as a few rulings on motions to dismiss (refer here), by and large, the cases remain only in their earliest stages.

 

Nevertheless some trends have begun to emerge, as detailed in the March 23, 2009 memorandum from the Gibson Dunn law firm entitled "Suprime-Related Securities Litigation: Early Trends" (here). The memo does a particularly good job categorizing the various kinds of allegations that plaintiffs have alleged as well as the defenses that defendants have asserted. As for what may lie ahead, the memo states that "there is unlikely to be any slowdown in the near future of new filings of securities cases related to the credit crisis."

 

The National Map of Bank Distress: The FDIC did not close any banks this past Friday night, so the number of year-to-date bank failures remains at 21, and the total number of bank failure since January 1, 2008 remains at 46.

 

Those readers who are tracking these banking-related developments closely may want to refer to this nifty interactive graphic (here) from TheStreet.com, on which they have plotted the bank closures since January 1, 2008 on a map of the United States. Cool.

 

Some Things in the Insurance Industry Never Change: In his enjoyable book about the rebuilding of London following the Great Fire of 1666 entitled London Rising, author Leo Hollis discusses the innovation Nicholas Barbon introduced when he launched "the first fire insurance company in the world." Hollis writes that

 

His scheme was brilliantly simple: it offered a defence against the risks of living in the city while also making him a healthy profit. For a premium of 2.5 per cent of the yearly rent for brick buildings and 5 per cent for wooden-frame structures he offered insurance against fire for terms of seven, eleven, twenty-one and thirty-one years. By the 1680s, he would have over four thousand subscribers.

 

However, insurance industry behavior pattern apparently were established even in the industry’s earliest days; Hollis notes that "the problem with innovation is that it is often copied and Barbon’s ideas were swiftly replicated." The City Corporation offered its own competing scheme and offered terms for life. Barbon "had to work hard to sell his services before the opposition stole his market," while the Corporation soon found "that it was offering too much to get customers."

 

So it may be said, with respect to the insurance industry’s apparently inexhaustible capacity for self-destructive competition, ‘twas ever thus.

 

And Finally: On behalf of everyone who has watched as much college basketball on TV over the last few weeks as I have, I would like to make a motion – that is, that every single person associated in any way with the production or distribution of the Taco Bell "nacho drag" commercial should be taken out and summarily shot, without benefit of clergy. All those in favor say "Aye."

 

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As the difficulties and challenges from the global economic crisis continue to mount, one recurring question has been – how could things possibly have gone so wrong?

 

One way to try to answer this question is to look at the root causes – that is, the financial and economic conditions that produced the current circumstances. A February 19, 2009 memorandum by my friend Faten Sabry of NERA Economic Consulting and her colleague Chudozie Okongwu and entitled "How Did We Get Here?: The Story of the Credit Crisis" (here) does an excellent job explaining how "problems that first manifested in a relatively small part of the mortgage market" have "led to a contagion" that has "quickly spread to threaten the liquidity and possible solvency of may financial institutions around the world."

 

As alternative to looking for root economic causes is to try to determine who, rather than what, is responsible for the current mess. It is perhaps inevitable given the magnitude of the current crisis that attempts would arise to assign blame. Time Magazine’s recently published gallery (here) of the 25 persons most responsible for the financial crisis is just one manifestation of this inevitable fault finding process.

 

The supposed regulatory shortcomings of the SEC are among the contributing factors cited by some commentators.Indeed, former SEC Chairman Christopher Cox is among those whose names appeared on the Time Magazine list.

 

With the SEC under scrutiny and facing questions, the incoming agency leadership faces pressure to burnish the agencies’ supervisory credentials. It appears that this rehabilitative exercise may include in part the assignment of responsibility for the financial crisis, a process that apparently may target corporate boards.

 

According to a February 20, 2009 Washington Post article entitled "SEC to Examine Boards’ Role in Financial Crisis" (here), one of new SEC Chairman Mary Schapiro’s "first tasks" will be looking into "whether the boards of banks and other financial institutions conducted effective oversight leading up to the financial crisis," as part of an SEC effort to "intensify scrutiny at the top levels of management."

 

This process, described as an "inquiry into what went wrong at the board level," will examine boards that "signed off on the risks the companies took." The Post article quotes observers who note that "the boards of top financial firms had characteristics that promoted risky business practices and harmed shareholders." Among the characteristics the article cites are: board members overloaded with commitments to multiple boards; failure to separate the CEO and Chairman functions; and insufficient oversight of compensation issues.

 

To a certain extent, the Post article, and perhaps even the reported SEC initiative to scrutinize boards, reflects something of a faulty premise. The article states that "with few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks. Whether or not boards have received "media attention," they certainly have not escaped scrutiny, as the boards of numerous companies already have been subjected to extensive private securities class action litigation by shareholders. Were there to be an SEC initiative targeting boards, plaintiffs’ attorneys’ undoubtedly would be emboldened to bring even further litigation in the SEC’s wake.

 

To be sure, the Post article also cites comments by other observers who question whether boards should be "held culpable for a financial crisis that just about everyone missed." One commentator observes that the "universe of people who misread the risks…is very broad" and "could extend to rating agencies, managements and regulators." (The mention of regulators’ own potential culpability adds a certain ironic note here.) Regrettably, in the current environment, this observation about the broad dispersion of culpability may represent less of a statement of exculpation that a justification for enlarging the list of persons on whom blame might be cast for the present predicament.

 

The causes of the current situation may be myriad and the responsibilities widely dispersed. Nevertheless, for cultural reasons buried deep in the American psyche, particularized blame apparently must be assigned. The prospect of the SEC deliberately targeting financial institutions’ boards unquestionably elevates directors’ potential liability exposures. This heightened exposure extends not only to the boards of the high profile companies that have already failed, been bailed out or been merged out of existence. It also extends to the boards of the many other banks, insurance companies and other financial institutions, and even companies outside the financial sector, that are currently struggling.

 

The prospect of heightened board scrutiny inevitably leads to questions concerning the adequacy of the potentially targeted board members’ D&O insurance. Now more than ever, board members will want to ensure that they have appropriate insurance structures in place to protect themselves should they attract the unwanted attention either of regulators or plaintiffs’ attorneys.

 

Potential Liability of Other Professionals: Consistent with the suggestion cited above that a wide range of persons potentially culpable for misreading the risks, investors seeking to recover their massive losses are targeting numerous other "gatekeepers," in addition to the directors and offices of the troubled companies. These gatekeepers include companies’ outside professionals, many of whom have been named as defendants in the subprime and credit crisis-related securities lawsuits.

 

On February 24, 2009 at 2:00 p.m. EST, the Securities Docket will be hosting a webcast on the "Liability of Professionals in the Financial Crisis." In this free webcast, Stuart Grant of Grant & Eisenhofer and Michael Young of Wilkie Farr and Gallagher will be addressing questions surrounding the potential liability of professionals such as auditors, investment bankers, rating agencies, lawyers and others.

 

For further information about the webcast and to register, refer here.

 

Did the Media Fail Their Gatekeeper Function, Too?: Add the media to the list of gatekeepers that arguably failed in their gatekeeper responsibilities. In a February 21, 2009 interview in the Wall Street Journal (here), NYU Professor Nouriel Roubini observes that

 

in the bubble years, everyone becomes a cheerleader, including the media. This is the time when journalists should be asking tough questions, and I think there was a failure there. The Masters of the Universe were always on the cover, or the front page -- the hedge-fund guys, the imperial CEO, private equity. I wish there had been more financial and business journalists, in the good years, who'd said, 'Wait a moment, if this man, or this firm, is making a 100% return a year, how do they do it? Is it because they're smarter than everybody else . . . or because they're taking so much risk they'll be bankrupt two years down the line?"

And I think, in the bubble years, no one asked the hard questions. A good journalist has to be one who, in good times, challenges the conventional wisdom. If you don't do that, you fail in one of your duties.

 

There is, it seems, no shortage of blame to spread around. The question remains whether anyone in particular can or should be held directly responsible for failing to see what no one else saw – and if so, whom.

 

The Week Ahead: The PLUS D&O Symposium: This week, I will be in NYC to help co-Chair the annual Professional Liability Underwriting Society (PLUS) D&O Symposium, which will take place on Wednesday, February 25, 2009 and Thursday 26, 2009, at the Marriott Marquis hotel in Times Square. Details about the Symposium, including the agenda and registration information, can be found here.

 

I know that many readers will be attending the Symposium, and I hope readers at the conference will make a point of greeting me, particularly if we have not previously met. I look forward to seeing everyone in New York.

 

Because of the Symposium and related PLUS duties and functions, The D&O Diary will not be appearing according to its usual schedule. Regular publication activities will resume next week.

 

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The recent news about the eleventh hour award of nearly $4 billion in bonuses to Merrill Lynch employees is only the latest in a series of events exciting enthusiasm for "clawbacks" of allegedly excessive or undeserved Wall Street bonuses. Reports that New York City financial firms disbursed $18.4 billion in cash bonuses is 2008 added further fuel to the fire.

 

Senator Chris Dodd stated, with particular reference to executives receiving bonuses from financial institutions benefiting from government bailouts, "I’m going to look at every possible legal means to get that money back," adding "I’m going to be urging – in fact not urging, demanding—that the Treasury Department figures some way to get the money back."

 

President Obama, for his part, referred to the award of bonuses during a recession and while financial companies are seeking financial help to be "shameful" and the "height of irresponsibility."

 

The idea of compelling executives to disgorge compensation has been a recurring part of the public discussion surrounding the current economic crisis. The suggestion that the government should clawback financiers’ prior compensation has been a rallying cry for academics (here) and commentators (here) alike.

 

Indeed, the Dealbook blog reports (here) from Davos that a discussion of the topic of executive compensation turned a conference session into " a bit of a lynch mob, Davos-style" in response to a proposal to force those financiers who benefitted from the boom to "disgorge some of the money they ‘earned’ in bonuses based on profits that have since vanished."

 

This lynch mob mentality is familiar to those who recall the public outcry that accompanied the last era of corporate scandals. In fact, the perceived compensation excesses at Enron and Tyco, among others, resulted in a statutory provision specifically designed for the purpose of clawing back unwarranted compensation, Section 304 of the Sarbanes Oxley Act.

 

Section 304 has in fact been used to recover executive compensation, in the noteworthy options backdating settlement involving UnitedHealth Group (about which refer here). However, the fact that over six years’ after the enactment of the statutory clawback provision that there is only one noteworthy example of its utilization underscores the provision’s limited usefulness.

 

Simply put, and as discussed in detail here, Section 304 has several critical limitations: the provision lacks a private right of action; the provision’s language is poorly written; and it can only be used against the CEO and the CFO, limiting its use against other executives.

 

Moreover, as discussed in a December 24, 2008 CFO.com article (here), a federal district court recently ruled that the provision cannot be enforced against a company’s CEO or CFO if the company did not restate its financial results, even if the company had accounting discrepancies. The restriction clearly could further limit the provision’s usefulness and could constrain the government’s attempt to use the provision to recover the recent controversial bonus payments.

 

There are, however, other legal avenues that litigants might pursue to try to recover executive compensation, as discussed in the January 29, 2009 New York Law Journal article entitled "Limiting, Clawing Back Executive Pay in the Wake of the Financial Bailout" (here) by David Pitofsky and Matthew Tulchin of the Goodwin Proctor law firm.

 

The authors note that while the business judgment rule traditionally has shielded compensation decisions "shareholders seeking equitable rescission and restitution via derivative suits have been successful in recovering ill-gotten gains, even in the absence of compelling proof of personal impropriety." The authors cite as an example the recovery of $40 million in bonuses from HealthSouth CEO Richard Scrushy.

 

The authors also reference the mixed results presented in recent attempts to use state corporate governance laws to recoup executive compensation. On the one hand, they note the unsuccessful regulatory efforts to recoup a $187 million compensation package from former NYSE Chairman Richard Grasso (about which refer here).

 

On the other hand, the authors also note the more recent and successful use of New York’s fraudulent conveyance laws by current New York Attorney General Andrew Cuomo, who obtained AIG’s agreement, in response to the Attorney General’s demand letter, to freeze salaries and eliminate bonuses for certain former top AIG executives. (An October 15, 2008 New York Times article discussing Cuomo’s letter can be found here.)

 

University of California law professor Jesse Fried, among others, suggests (here) that the New York fraudulent conveyance laws, upon which Cuomo relied in his efforts involving AIG, might be used to recover unwarranted bonuses. Fried points out that the statute applies to all firms in New York, even those that have not applied for bankruptcy, and gives creditors the right to recover payments made to insiders under certain circumstances.

 

Provisions regarding executive pay were in fact a part of the federal bailout bill enacted by Congress last fall. However, amendments specify that the provision only applies to firms that receive government bailout funds by selling assets to the government in an auction. Because the bailout funds have not been deployed as originally intended to buy assets, the compensation recoupment provision may prove "toothless," as discussed in a December 18, 2008 Washington Post article (here).

 

Nevertheless, the lynch mob mentality in evidence at Davos is likely to continue to arise elsewhere, and in all likelihood, popular interest in recouping executive compensation will continue as a prominent topic while Congress continues to grapple with the current economic crisis.

 

Among other things, we can also expect continued discussion on whether or not Congress should enact a legislative limit on executive pay, as discussed in Robert Frank’s January 3, 3009 New York Times column (here).

 

In addition we can expect increasing pressure on companies to adopt their own clawback provisions, either as part of their incentive compensation plan, as governance policy, or as a statement of intent. My prior post discussing corporate clawback policies can be found here.

 

Whenever the issue of possible litigation against corporate officials comes up, the question arises concerning who will bear the costs. Obviously, the amounts of any compensation clawed back or disgorged would not be covered by the typical D&O policy. However, under the wording of the typical policy, a corporate official that is the target of a compensation clawback lawsuit would have substantial grounds on which to argue that his or her costs of defending against the suit should be covered.

 

To the extent that current popular sentiment for compensation recoupment translates into litigation, the resulting defense expense could become yet another area of growing claims expense for increasingly beleaguered insurers.

 

The Heat is On: Banco Santander started it, with its offer to make good on its clients' Madoff related losses. The word is out now, and at least some other banks have gotten the message.

 

As reported in the January 29, 2009 Financial Times (here), the National Bank of Kuwait has fully reimbursed all of its clients that lost money on the Madoff-related Ponzi scheme -- full reimbursement meaning both the clients initial investment as well as "the gains, thought to be ficticious, that they thought they had made."

 

As the Financial TImes article notes, the NBK move "puts pressure on other banks and fund managers whose clients lost money in Mr. Madoff's alleged fraud." (I wonder why the FT found it necessary to add the work "alleged.") The article goes on to note that NBK had the advantage of relatiively small losses to cover

 

Proud to Be a ‘KM Pick’: Knowledge Mosaic, the online subscription information service for attorneys, regulators, journalists and academics, offers a number of excellent services, including a weekly newsletter entitled Wired Mosaic. A feature of the newsletter is the KM Pick, in which the newsletter highlights a legal-oriented blog.

 

I am proud to report that in the January 29, 2009 issue of the newsletter (here), The D&O Diary is featured as the KM Pick. Modesty prevents me from reciting here the blush-inducing words of the newsletter's glowing encomium, but suffice it to say that I sure hope everyone will take a look at the item (right hand column, scroll down).

 

 

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One of the legacies of the era of corporate scandals earlier in this decade is a heightened awareness of corporate governance issues. This development is most obvious for publicly traded companies in the United States, with the governance requirements embodied in the form of the Sarbanes-Oxley Act. The heightened governance awareness has also had spill-over effects for private companies (refer here) and even non-profit entities (refer here).

 

But there are many other types of non-listed firms, beyond just private companies and non-profit enterprises – including joint ventures and family-owned firms, as well as venture funds, private equity firms and hedge funds. The heightened governance awareness has also affected these other kinds of non-listed firms. But many of the principles and practices developed for publicly traded companies may be ill-suited to these other kinds of non-listed firms.

 

 

In a comprehensive book entitled “Corporate Governance of Non-Listed Companies” (here), Professors Joseph McCahery of the University of Amsterdam and Erik P.M. Vermuelen of Tilberg University take a look at corporate governance principles and practices for these other kinds of non-listed firms.

 

 

The professors begin with observations about current attitudes toward governance, particularly those evolved from the context of publicly traded companies. They note that “it could very well be argued that non-listed companies do not always benefit from the spill-over effect of the application of disproportionate governance rules” and that a “corporate governance framework that is not consistent with the social and economic requirement of non-listed companies will yield imperfections over time.”

 

 

In their book, the authors propose a corporate governance framework for non-listed firms that will “foster strong decision-making, accountability, transparency and ultimately firm performance.”

The authors organize their corporate governance analysis around “three pillars.” The “core pillar” represents “company law, which provides rules and standards for registration and formation, organization and operation.” The second pillar consists of “contractual mechanisms, such as joint venture agreements and shareholder limitations.” The third pillar consists of the non-listed firms “embrace of the corporate governance rules and principles that are tailored to the organization of their publicly held counterparts.”

 

 

The authors’ exhaustive overview of the transjurisdictional development of “company law” demonstrates how various legal norms have evolved in many jurisdictions to address concerns arising from the need to protect investors and creditors from “managerial opportunism.” But these paramount principles of governance for publicly traded firms, whose ownership is widely dispersed and at an informational disadvantage to management, may not be as relevant within the ownership structures of non-listed firms.

 

 

Because of the differing needs and structures of non-listed firms, many of their governance requirements and expectations are highly contractual in nature, and tend to be more focused on protecting one set of owners and shareholders from another set of owners or shareholders. These contractual arrangements tend to address “four fundamental elements – risk of losses, return, control and duration.”

 

 

From the authors’ perspective, the value and importance of these contractual arrangements underscores the limitations of a “one-size-fits-all” approach to corporate governance and also militates against the regulatory imposition of rigid governance mandates on non-listed companies. The authors particularly address these concerns in depth in the context of private equity firms and hedge funds.

 

The third pillar of the authors’ governance framework pertains to non-listed firms’ voluntary adoption of governance measures to improve transparency and accountability. The authors suggest that companies have “strong incentives to adopt or disregard governance recommendations based on a cost-benefit assessment.” Non-listed firms have a “high-powered incentive to comply with corporate governance provisions.” The implementation of appropriate internal control measures, for example can “(1) reduce financial/reporting errors; (2) help firms follow their business practices and performance; (3) assist in tracking inventory; and (4) signal potential weaknesses within the firm.”

 

 

The authors argue for the adoption of an “optimal set of recommendations” that not only would “create a dynamic and sustainable network of business practices and advice tailored to the needs of non-listed companies” but would also “head off legislative pressures.” The “steady and healthy growth” of these kinds of firms, which are so critical to overall economic growth and development, would be advanced by their implementation of mechanisms ensuring that

 

(a) financial statements fairly present the performance of the business; (b) independent and knowledgeable directors and/or supervisors are appointed; (c) audit committees are established; and (d) strong internal control systems and processes reduce business risks and lower costs.

 

The authors’ ultimate point is that “the ‘one-size-fits-all’ and regulatory mentality arguably led to some undesirable spill-over effects to non-listed companies.” They advocate “the introduction of a separate approach” based on the development of guidelines for non-listed firms that are “sufficiently attractive and coherent from a cost-benefit perspective to persuade non-listed companies to opt into a well-tailored framework of legal mechanisms and norms.” The authors conclude that non-listed companies that operate under “well-designed and effective governance structures are likely to perform better and consequently will be more attractive to external investors.”

 

 

The authors’ analysis of the limitations of a one-size-fits-all approach to corporate governance is well-founded, and indeed these concerns may be valid even among listed companies as well as between listed companies and their non-listed counterparts. The authors’ analysis of the possibilities for and limitations of contractual mechanisms for non-listed companies is perceptive, particularly with regard to private equity firms and hedge funds.

 

 

In the end, the implementation of effective governance mechanisms and controls is critical for all firms, regardless of the particular form within which any specific firm operates. The most critical point is that mechanisms adopted must be suited to the form in which any particular firm does business. Mandatory regulatory requirements may not be sufficiently sensitive to the differing needs of different kinds of firms.

 

 

Very special thanks to Professor McCahery for providing me with a copy of this excellent book.

 

 

Olympic Questions:

 

1. Am I the only one that found the opening ceremonies scary?

 

2. Who decided beach volleyball is such a big deal?

 

3. Why does Bob Costas think Cris Collinsworth is so damned funny?

 

4. How did Mark Spitz win seven gold medals without a swim cap or goggles?

 

5. Bela Karolyi. Discuss.  

 

6. Why do so many commercials (including political ads for both Presidential candidates) have images of wind turbines?

 

7. With a 32-year old winning two swimming relay gold medals, a 38-year old winning the women’s marathon, a 33-year old female gymnast winning silver in the vault competition,  and a 41-year old winning two swimming silver medals, is it possible the Chinese are on the wrong track with their prepubescent “women’s” gymnastics team? 

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One of the received truths from the era of corporate scandals earlier this decade is that corporate governance matters. As a result, a high-profile part of the current assessment of any company is whether or not the company practices “good” governance. Even though the evaluation of any particular company’s governance has an eye-of-the-beholder aspect, several different commercial enterprises have emerged in recent years, each offering to provide their subscribers with objective governance ratings.

 

In the space of just a few short years, these governance ratings have become ubiquitous. They are now a critical part of company evaluations for investors, regulators, the financial press, and even D&O insurance underwriters. The quick acceptance of these ratings suggests that they meet a widely perceived need. However, their wide acceptance notwithstanding, it is still worth asking what exactly these ratings actually tell us about the companies and future company performance.

 

In a June 26, 2008 paper entitled “Rating the Ratings: How Good Are Commercial Governance Ratings?” (here), Stanford Law Professors Robert Daines and Ian Gow, and Stanford Business School Professor David Larcher examine four leading ratings firms’ ratings and analyze “the association between these ratings and future firm performance and undesirable outcomes such as accounting restatements and shareholder litigation.”

 

The authors reach a number of provocative conclusions, including in particular their finding that “the level of predictive validity for these ratings is well below the threshold necessary to support the bold claims made for them” by the commercial ratings firms.

 

The authors examined the corporate governance ratings produced by Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), Governance Metrics International, and The Corporate Library. The authors compiled ratings for U.S. firms for each of the four ratings services, cover the period from late 2005 to early 2007. The analysis was primarily focused on ratings available as of December 31, 2005, as that was the earliest date at which the authors established “a sizeable cross-section of ratings across the four ratings firms.”

 

The authors first looked at whether the various ratings were at least consistent with each other. The authors noted that “if, as seems to be often posited, there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it, then we would expect these measure to be highly correlated.”

 

However, the authors found that there is “surprisingly little cross-sectional correlation among the ratings.” Indeed, the ratings are “close to being uncorrelated.”

 

In particular, the authors found that in certain instances, the various ratings rated specific companies dramatically differently. The authors concluded that “either the ratings are measuring very different corporate governance constructs and/or there is a high degree of measurement error (i.e., scores that are not reliable) in the rating process across the firms.”

 

With respect to future outcomes, the authors found that three of the ratings have “a very modest ability to predict accounting restatements” and two of the ratings have “a very modest ability to predict class action lawsuits.” The authors further concluded that at least one rating firm’s ratings exhibited “virtually no predictive validity.” Overall, the authors concluded that “the level of predictive validity even for the best ratings is well below the threshold necessary to support the bold claims by the corporate rating firms.”

 

The authors’ observation about the lack of agreement between the four ratings is, to me at least, unsurprising, as they various ratings clearly aim to measure different things, based on different visions of “good governance.” Even though “good governance” is a widely used term, there is no consensus definition. As the authors themselves note, “defining good governance and distinguishing good governance from bad governance has proved…elusive.”

 

The authors’ conclusions about the ratings’ relative lack of predictive power undoubtedly will be disputed by the ratings firms themselves. From my perspective, the authors’ overall conclusion about the ratings’ overall lack of strong predictive power is unsurprising, particularly as it relates to predicting securities class action litigation.

 

In my prior life running a D&O underwriting facility, my colleagues and I spent a great deal of time and effort attempting to determine what factors might predict securities litigation. We had conjectured early on that corporate governance might afford a useful tool in segmenting litigation risk. Over many years’ time,  we concluded that corporate governance alone was not sufficiently predictive of securities litigation risk, and that certain other criteria (including company size, industry, and age) were much more highly correlated with securities litigation risk.

 

Because of this experience, my colleagues and I were always somewhat skeptical of commercial governance-based securities litigation prediction tools. In my own experience, these tools are at their best when used negatively, that is, when identifying companies to avoid, but they were less helpful when used to determine which risks to accept, which is of course how D&O underwriters earn their keep.

 

The authors’ conclusions are more or less consistent with my own experience on these points. However, the real value of the authors’ thorough examination of these issues is that it will likely start a dialogue on these issues. It may well be that a different analysis or a different approach might support a different conclusion about the predictive power of the ratings.

 

Indeed, the authors themselves expressly acknowledge that they might not have used the “right model” to measure the ratings, and that “given the right model specification,” the ratings “might well prove to be significant and informative.” The authors state that, to the degree this is true, then the ratings firms should “disclose the ‘right’ model” and disclose “how well their ratings predict future performance using the ‘right’ model.” This disclosure “would enable investors to evaluate the net benefits produced by their purchase of the ratings.”

 

The authors’ interesting analysis and discussion undoubtedly will provoke debate, particularly in the corporate governance community itself. I would welcome responsible comments from the representatives of the ratings firms who might wish to respond on this blog to the authors’ conclusions about the ratings’ predictive power. (PLEASE see below for responses.)

 

 A June 30, 2008 Stanford Law School press release describing the article can be found here. A June 26, 2008 Fortune report discussing the article can be found here.

 

Very special thank to the authors for their permission to quote their article on this blog.

UPDATE: In response to my invitation to the governance rating firms to respond to the authors's study, Ric Marshall, the Chief Analyst at The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, submitted this repsonse:

Thank you for your invitation to respond to the recent Stanford study regarding the predictive value of governance ratings, including those of The Corporate Library (TCL).
 
The study found that TCL’s ratings have a statistically significant ability to predict accounting restatements and future operating performance. In addition, at the extremes (very poor or very good ratings), the study found that our ratings correlated with future alpha.  The authors state that these relationships are modest, and suggest that they may be inadequate to make our ratings useful. Our clients, however, who come from a wide range of industries, do find value in our ratings. For example, a portfolio manager who has used our ratings over the past four years in stock selection has told us that doing so has contributed substantially to his returns; our insurance clients regularly and successfully employ our ratings to identify companies that warrant greater due diligence and may present higher risk.
 
We understand that, as you point out in your recent posting about the study, it is not always effective to use governance indicators alone as a guide to financial or litigation risk.  Indeed, most of our clients combine our ratings with a number of other tools, and our own Securities Litigation Risk Analyst Ratings (which were not examined in the Stanford study) combine governance data with a number of financial and industry-related variables. We also agree with your assessment that governance indicators are often most useful in identifying areas of concern, rather than strengths; this is the essence of our approach. Client feedback has shown that taking governance ratings into account, especially in cases where doing so helps chiefly to avoid problems, brings substantial benefits to their businesses.  The Stanford study suggests that corporations themselves tend to agree: according to interviews the authors conducted with boards of directors, they often use low governance ratings as a red flag indicating that they should step up monitoring.
 
The authors’ surprise at how “little cross-sectional correlation” they found among these ratings reveals the study’s chief flaw, which is the assumption that, “there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it.” This is not the case at all, as each of the four rating services reviewed have a different focus, and are employed in different ways by a wide range of commercial clients. While Riskmetrics and GMI do both measure ‘good governance’ against specific standards, our own focus is on identifying governance weaknesses and thereby companies for clients to avoid. We have always taken issue with the notion that any one governance model can be the most effective for every company.

Special thanks to Ric and Beverly for taking the time to provide a detailed written response.

FURTHER UPDATE: Jack Zwingli, the CEO of Audit Integrity, has also provided a detailed response to the academic study. Jack's response can be found here.
 

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If the facts don’t fit, you must remit. That seems to be the view of an increasing number of companies, as they have adopted provisions requiring repayment of executive compensation found to have been based on incorrect financial statements.

The concept of compensation clawbacks was actually built into the Sarbanes Oxley Act. Section 304 requires CFOs and CEOs to reimburse their companies for incentive compensation and stock sales profits if the financial statements for that year are restated and the restatement is due to “misconduct.”

According to a June 2008 report (here) from the Corporate Library, an increasing number of companies have adopted their own clawback provisions, “either as part of the rules of an incentive plan, as governance policy, or simply as a board statement of intent.”

In its prior 2003 review, the Corporate Library had found that just 14 companies had adopted clawback provisions. But in its June 2008 survey, the report found that 295 of the 2,121 companies examined had “disclosed the adoption and implementation of a clawback provision of one kind or another.”

The survey found that the provisions vary from company to company, but could generally be classified as either “performance based” (if the provision applies to all executives who received an incentive payment of some kind based on incorrect financial) and “fraud based” (if it applies only to those executives who have engaged in fraudulent activity or misconduct that has caused a restatement). The survey found that 44.4% of the clawback provisions were “fraud-based” and 39% were “performance based.” An additional 16.6% of the provisions could not be classified.

The report cites several examples of the clawback provisions and even notes one example, involving Warnaco, in which a clawback has already occurred. The company reported in this year’s proxy statement (here, see page 21) that its compensation committee had cut the incentive pay for three executives in 2006 by a total of $120,000. The reduction occurred after the company restated its 2005 financial results due to certain accounting errors and irregularities.

These kinds of provisions have the support of various governance groups. As the June 8, 2008 New York Times stated in an article discussing the Corporate Library report (here), “why should executives keep compensation if it is discovered later that benchmarks were unmet?”

Not only do these kinds of provisions address basic principles of pay equity; they may also have a deterrent effect as well. Indeed, a June 4, 2008 CFO.com article entitled “Clawbacks Claw Their Way Into Corporate Strategy” (here), comments that “the emergence of clawbacks could be one factor in the recent decline in the number of financial restatements.” (For further background regarding the declining number of restatements, refer here.)

The possibility of a compensation clawback is not the only consequences that could affect executives at restating companies. A March 2008 study by Juan Manual Sanchez and Adi Masli of the University of Arkansas Sam M. Walton School of Business, Denton Collins of Texas Tech University, and Austin Reitenga of the University of Alabama entitled “Earnings Restatements, the Sarbanes-Oxley Act and the Disciplining of Chief Financial Officers” (here) found not only that companies restating earnings “have higher rates of involuntary CFO turnover,” but that CFOs of restating companies “face stiff labor market penalties.”

The authors looked at 167 restating companies and then matched them with a control company of comparable industry, size and age. The authors looked for instances where CFOs left the restating company within two years of the restatement. They then tracked the CFOs for four years to determine their subsequent employment.

The authors found “higher CFO turnover rates following restatements in both the pre- and post-SOX periods, which implies that governance mechanisms served to identify and discipline CFOs implicated in the restatements in both periods.”

The authors also found that “former CFOs of restatement firms are less likely to find a position with a job title that is comparable to their prior CFO position, less likely to find employment in a publicly traded company, or less likely to find a comparable position in a public firm.”

Finally, the authors found that “executives terminated in the post-SOX period appear to suffer greater reputational/labor-market penalties compared to the pre-SOX period, suggesting that firms are less willing in the post-SOX period to hire a former CFO with a tarnished reputation. This appears to be consistent with the intent of the legislation to increase executive accountability.”

With all the disincentives for bad behavior, one might optimistically hope that the sins of the past will not recur. Unfortunately, certain aspects of the current credit crisis arguably belie that hope. Nevertheless, one useful takeaway from this analysis is that the presence of corporate clawbacks could provide a deterrent for bad behavior, and could be a positive risk assessment factor.

Hat tip to the CFO.com for the reference to the academics research paper about career consequences for CFOs of restating companies.

Update on a Backdating Settlement That Went Awry: In a prior post (here), I discussed the recent opinion in which Judge Alsup used harsh language in rejecting the Zoran options backdating-related derivative lawsuit settlement. Among other things, Judge Zoran questioned the parties’ representations of the settlement’s value, and questioned the absence of any cash payment to the corporation.

According to a June 9, 2008 Forbes article entitled “Fee Fixers” (here), “it turns out that Alsup was on to something.” According to the article, on May 29, the lawyers resubmitted the settlement, but this time, the settlement included $3.4 million in cash, $3 million from Zoran’s insurance company and $395,000 from Zoran’s CEO and another executive. The article noted that “for having done such a good job,” the plaintiffs’ lawyers “have requested $1.5 million in fees and expenses, $300,000 more that the first time around.”

According to the company’s June 12, 2008 press release (here), Judge Alsup has granted preliminary approval to the settlement. The rejiggered settlement may have passed judicial muster. But let’s be explicit about what the sequence of events really consists of.  Basically, and other than with respect to the $395,000 payment, the insurance company is being asked to pony up the additional $3 million, and undoubtedly will also be called upon to pay the additional increment in the plaintiffs’ fees, as well as all of the additional defense expense incurred after the first settlement cratered. Perhaps there is nothing remarkable in all of this. But at some point, you really do start to wonder about the social utility of all of this activity. It is enough to make anybody cynical.

Hat tip to the 10b5-Daily (here) for the link to the Forbes article. Special thanks to Zusha Ellinson of The Recorder for the link to the Zoran press release.

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In October 2000, the SEC promulgated Rule 10b5-1 to provide company insiders with a way to trade their shares in company stock without incurring securities law liability, through the pre-trading adoption of a written trading plan. Despite the Rule’s protective purpose, concerns have arisen more recently about Rule 10b5-1 plan abuses, as I noted in prior posts (here and here).

 

Indeed, concerns about Angelo Mozilo’s possible Rule 10b5-1 plan misuse were an important part of the court’s recent refusal to dismiss the Countrywide subprime-related derivative lawsuit. (My prior post about the Countrywide dismissal denial can be found here. A more detailed analysis of the Countrywide court’s discussion of Rule 10b5-1 plan issues can be found on The Corporate Counsel.net blog, here.)

 

A May 27, 2008 paper by University of Chicago Law Professor Todd Henderson, Stanford Business School Professor Alan Jagolinzer, and Penn State Business Professor Karl Muller entitled “Scienter Disclosure” (here) looks at Rule 10b5-1 plans from a different perspective, asking what can be inferred from a company’s disclosure of its officials’ plans. The authors’ surprising conclusion is that the more detailed a company’s plan disclosure, the more likely are the subsequent trades to capture abnormal trading returns.

 

The starting point of the authors’ analysis is that, although Rule 10b5-1 itself does not require the plans to be disclosed, “disclosure can enhance the legal protection by increasing the likelihood of early dismissal of class action lawsuits.” This “litigation benefit” arises due to the fact a Rule 10b5-1 plan trading defense will only be available at to dismissal stage if the plan is identified and described in the company’s SEC filings (which a court may consider at the initial pleading stage). If the company fully discloses the plan details, “a court may better ascertain that the allegedly fraudulent trades fall within the Rule’s affirmative defense, thereby increasing the possibility of a low-cost dismissal.”

 

From this, the authors infer that companies perceiving a greater litigation risk are “more apt to disclose the existence and details of Rule 10b5-1 plans.” But there are costs associated with disclosing the plans, particularly “if investors infer a price relevant signal from disclosure or if disclosure enhances investors’ monitoring of insiders’ trade plan commitment.” The “signal” might encourage investor “front running” which could deprive the insider of anticipated trading profits. The monitoring “reduces the value of early termination options” the insider might have if a planned trade no longer appears desirable.

 

The authors hypothesized that insiders will nonetheless prefer Rule 10b5-1 plan disclosure if the “scienter disclosure” provides incremental litigation benefit – which is likely to be greatest precisely where the ability to trade provides the greatest opportunity to profit. That is, “pre-disclosure of trade may be strategic in the face of high legal risk if it mitigates legal risk and does not fully reveal privately held information.”

 

The authors examined company disclosures for hundreds of companies during the period between October 2000 and December 2006, and grouped the companies according to whether the companies had low, moderate or detailed Rule 10b5-1 plan disclosure. The authors then correlated the companies’ disclosure and “subsequent firm returns and earning performance.” The authors found that “more specific 10b5-1 plan disclosures are associated with more negative post-trade abnormal returns” and that “the association between sales transactions and subsequent negative performance is increasing in disclosure specificity, after controlling for other factors that are associated with firm returns.”

 

As a group, executives at those companies with the most detailed disclosure avoided an average of 12% loss in the companies’ trades relative to the broader market in the six months following their sales. The authors conclude that “voluntary Rule 10b5-1 plan disclosure is associated with the higher level firm legal risk and a proxy for insider’s potential strategic trade.”

 

In other words, the more detailed disclosure manifests insiders’ perception that subsequent trades are more likely to be advantageous – and therefore legal protection is more likely to be important, justifying the detailed disclosure.

 

These data suggest, and the authors hypothesize, that “investors should respond negatively to specific disclosures regarding 10b5-1 participation, if they infer that insiders have high strategic trade potential for which they seek high litigation protection.” However, the authors found that there is no observable negative investor response to Rule 10b5-1 disclosure.

 

The authors’ conclusions have a number of important implications. Obviously, investors may be missing an important signal related to 10b5-1 disclosure. Another important implication relates to the protection that the Rule affords; the authors’ conclusion that the companies with the most detailed disclosure are also the ones with the most fortunate timing suggests that, at least in some companies, transparency may be facilitating aggressive stock sales. The Rule was designed to provide company officials with a way to trade safely, but the authors’ study suggests that at least some company officials may be using the Rule as a shield to unload stock at an opportune time.

 

While I confess that initially I found the authors’ conclusions troubling, after further reflection I am less concerned. The problem here is not that insiders are using Rule 10b5-1 plans and plan disclosure strategically – after all, the whole idea of the Rule was to facilitate trading, and there is certainly no suggestion that trades made pursuant to the Rule cannot be advantageous. The problem is that at least so far, investors have missed the negative signal that Rule 10b5-1 plan disclosure implies.

 

The authors themselves speculate that the absence of negative investor reaction “may indicate that there are frictions to implementing strategies based on 10b5-1 disclosure signals or that investors do not understand 10b5-1 disclosure implications, which is possible if our same period reflects the transition period regarding 10b5-1 use.” To the extent, however, that the signal is better understood, the more the marketplace itself will discipline the process.

 

The greater likelihood that the mere announcement of a 10b5-1 plan could undermine a company’s share price could provide a missing disciplinary constraint on strategic trading and reduce company officials’ ability to capture abnormal returns. In other words, the whole mechanism will function better if investors appreciate the significance of 10b5-1 disclosure – an appreciation that the authors’ research clearly should facilitate.

 

A May 27, 2008 USA Today article discussing the authors’ study can be found here. An entry on the University of Chicago Law School Faculty Blog discussing the article can be found here.

 

Very special thanks to Professor Henderson for alerting me to the article and for providing me with a link.

 

Another Options Backdating-Related Class Action Settlement: In its May 8, 2008 filing (here), Kratos Defense & Security Solutions (formerly known as Wireless Facilities) announced that in March 2008, it had reached a tentative agreement to settle the options backdating-related securities class action lawsuit pending against the company and certain of its directors and officers. The amount of the settlement is $4.5 million, of which $1.7 million will come from the company and the balance of which will come from the company’s D&O insurer.

 

I have added this settlement to my table of options backdating-related lawsuit settlements and dismissals, which can be accessed here.

 

Hat tip to Adam Savett of the Securities Litigation Watch blog (here) for providing the heads’ up about the Wireless Facilities settlement

 

Not Just Immune, But Infallible: If you were immensely rich and powerful, you too might well, as did the Sultan of Brunei in 2004, amend the constitution to “declare himself infallible and immune from any obligation to appear in court …and to subject anyone who criticizes him to criminal punishment.”

 

Those curious to know how a court might actually apply a provision like this and related legal issues will want to refer to Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), in which Pileggi reviews a May 23, 2008 Delaware Chancery Court decisions involving the Sultan and his brother. Among other things, Pileggi notes that in the course of reaching its decision, the Court “recites the background facts of royal family battles that could be part of a movie script.”

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One of the legacies from the era of the corporate scandals is the lasting image of certain corporate leaders as “imperial CEOs” (refer here) – that is, as greedy, power hungry overlords who exploited their companies to their own enrichment and to the shareholders’ detriment. Excessive CEO pay remains a widely perceived marker for poor corporate governance and even for securities litigation risk. But recent scholarly analysis of senior corporate executive compensation suggests that outsized CEO pay may not only indicated weak governance, but may also be associated with company underperformance.

In a paper most recently revised in May 2008 entitled “CEO Centrality” (here), Lucian Bebchuk of Harvard, Martijn Creamers of Yale and Urs Peyer of INSEAD “examine the relationship between CEO centrality – the relative performance of the CEO within the top executive team in terms of ability, contribution and power – and the value, performance and behavior of public firms.”

In order to measure so-called CEO centrality, the authors used as a measure “the CEOs pay slice” (CPS) – that is, the “percentage of the aggregate compensation awareded to the firm’s top five executives captured by the CEO.” The authors hypothesized that higher CPS “will tend to reflect a greater relative performance of the CEO within the top executive team.”

In order to compute each CEO’s pay slice, the authors used data from Compustat’s ExecuComp databse from 1993-2004. The authors attempted to control for some factors that could influence the CPS, including the CEO’s tenure, the CEO's status as a large owner or founder, and the size of the company’s aggregate top-five compensation relative to peers.

The authors concluded that CEO centrality has a “rich set of relations with firms’ behavior and performance.” Specifically, the authors concluded that CEO centrality is correlated with

(i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO’s receiving a “lucky” option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, and (vi) lower firm-specific variability of stock returns over time.

The apparent correlation of outsized CEO compensation and “firms’ behavior and performance” tends to corroborate the view expressed, for example, by the Corporate Library (here), that “CEO compensation practices that are poorly aligned with shareholder interests remain a powerful indicator of potential securities litigation.”

While the authors’ conclusions seem intuitively correct to me, I do wonder whether certain aspects of the analysis are a refection of the time spread of the data used. The database is heavily weighted to the 90s and to the era before the corporate scandals and before the recent increased focus on corporate governance and on executive compensation. It might be interesting for the authors to perform the same analysis but to use only data from the five years after the enactment of the Sarbanes-Oxley Act. Perhaps the conclusions would be the same, but I do wonder whether or not the correlations would be as strong for the more recent years.

CEO compensation practices obviously are critical, but CFO compensation practices may also be significant, as I discussed on a recent post (here).

Countrwide Derivative Lawsuit to Proceed: According to a May 15, 2008 New York Times article (here), Judge Mariana Pfaelzer of the Federal District Court in Los Angeles has denied the defendants' motion to dismiss the shareholders' derivative lawsuit that has been filed against Countrywide Financial, as nominal defendant, and certain of its directors and officers. (A description of the lawsuit can be found here.)

The opinion is not yet posted on PACER so I have not had a chance to review it yet, but from the description in the times it sounds like it could be worth reading. Among other things, Judge Pfaelzer said, with respect to Angelo Mozillo's frequently revised 10b5-1 plan, "Mozillo's actions appear to defeat the very purpose of the 10b5-1 plans."  I will try to add a link to the opinion here when I can get my hands on a copy. (I would be grateful if any reader with access to the opinion could forward me a copy.)

UPDATE: A copy of the court's May 14, 2008 order in the Countrywide Derivative case can be found here.

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It is generally understood that under Delaware law, directors enjoy broad rights of indemnification and advancement. The Delaware statutory regime does allow corporations a great deal of flexibility in how they adapt these provisions to their own circumstances. But while these principles are generally understood, it may nevertheless come as a surprise to many that a corporation’s flexibility to adjust the provisions includes the ability to eliminate former directors' advancement  rights, at least according to a recent Delaware Chancery Court opinion.

A March 28, 2008 opinion in Schoon v. Troy Corporation (here) by Vice Chancellor Stephen P. Lamb held that as a result of a board approved by-law amendment eliminating advancement rights for former directors, a former company director did not have the right to advancement of attorneys’ fees.

The company’s by-law had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.” After one of the company’s directors left the board but before the director became involved in litigation relating to his prior board service, the company’s board deleted the by-law’s reference to former directors.

The former director argued to the court that his right to advancement had vested when he commenced his board service. The former director also sought to rely on a prior Delaware court decision which had held that a board cannot terminate a former director’s advancement rights while litigation is pending. Vice Chancellor Lamb rejected the former director’s arguments, holding that the director’s advancement rights do not become “vested” until litigation is actually commenced.

As Steven M. Haas of the Hunton & Williams law firm noted on the Harvard Law School Corporate Governance Blog (here), “[t]his holding may surprise some practitioners, given that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board.”

The possibility that directors could lose their rights to indemnification or advancement after they leave the board may not only “surprise some practitioners,” but it would shock many directors, whom I believe rightly would be appalled to learn that they could be stripped of these rights after they leave the board. At a minimum, this holding strongly reinforces the need for each director to have their own separate indemnification agreement with the company, to reduce the possibility for a later board to eliminate these rights after the director has left board service. Without a separate contractual undertaking, directors may have no assurance that after they leave the board their rights to advancement and indemnification will be preserved.

At the same time, however, it should be emphasized that most directors and officers liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom corporate advancement and indemnification has been withheld would still have right to seek defense expense protection and indemnification under the company’s D&O liability policy. There might be some question about which retention would apply under the policy, but that issue aside, the insurance coverage should be available to protect the former director (subject to all of its terms and conditions).

Accordingly, In most circumstances, the company’s D&O insurance program should provide adequate protection even for former directors – assuming that the company has procured and continued to maintain insurance protection, and assuming further that the limits available under the insurance program are not otherwise consumed by other insured persons’ defense expense and indemnity requirements.

For directors who have left board service and who are concerned that events could conspire (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance) to leave them unprotected, there is another insurance solution available. That is, a director concerned about these circumstances may want to consider a so-called former director and officer liability insurance policy. This kind of coverage, which was described at greater length in a recent CFO.com article (here) is buyer-specific; that is, it belong exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others. It is also noncancelable, nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point that should not be lost here is that the director in the case cited above lost his anticipated rights after he left the board. Directors concerned about their rights following board service will want to fully consider the available insurance alternatives.

The Ropes & Gray law firm has a May 5, 2008 memorandum (here) discussing the ways in which by-laws and indemnification agreements might be modified to protect against retroactive elimination of directors' rights.

The Delaware Corporate and Commercial Litigation Blog has a post (here) discussing other aspects of the Schoon v. Troy decision.

Speakers’ Corner: On May 6, 2008, I will be in Montreal, Quebec, participating in a panel sponsored by the Canadian Chapter of the Professional Liability Underwriting Society (PLUS). The panel (more information about which can be found here) is entitled “The Subprime Meltdown and its Impact on the Canadian Insurance Landscape” and includes a number of distinguished speakers, included Dr. Faten Sabry of NERA Economic Consulting, David Williams of Chubb, and Denis Durand of Jarislowsky Fraser Limited.

In addition, on May 8, 2008, I will be moderating a panel at a American Bar Association Tort Trial and Insurance Practice Section conference in New York. The title of the conference is "Beyond Legal: A Business Approach to Corporate Governance" and the panel is entitled "Identifying, Predicting and Minimizing Securities Litigation Risk." Joining me on the panel will be Nell Minow of the Corporate Library, Professor Eric Talley of the Boalt Hall School of Law at UC Berkeley, and Patrick McGurn of RiskMetrics. A copy of the conference brochure can be found here.

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Commentators have long focused on CEO compensation as a leading corporate governance concern. Indeed, the Corporate Library has even suggested (here) that CEO compensation practices that “are poorly-aligned with shareholder interests” are “a powerful indicator of potential securities litigation.” While CEO compensation unquestionably is an important issue, academic research recently published by three Michigan State professors suggests that the CFO’s compensation may be even more important than that of the CEO.

In an April 15, 2008 paper entitled “CFOs and CEOs: Who Has the Most Influence on Earnings Management”(here),  John Jiang, Kathy Petroni and Isabel Yanan Wang report on their investigation “whether CFOs’ equity incentives are associated with earnings management, and whether earnings management is more sensitive to CFOs’ equity incentives than to those of the CEOs.” Prior research has focused primarily on CEOs’ compensation, based on conventional wisdom that because CEOs’ equity compensation was greater than that of CFOs, it should be more influential. In addition, it was generally presumed that because the CFO is the CEO’s agent and the CEO has the power to replace the CFO, “CFOs do not respond directly to their own equity incentives but only to the wishes of their CEO.”

Contrary to these prior assumptions, the authors posited that CFOs equity incentives “may have a stronger impact on earnings management than those of the CEOs, because CFOs have the ultimate responsibility for the management of the financial system, including the preparation of the financial report.”

The authors used a database for the S&P 1500 for the period 1993 through 2006, representing 17,542 firm years of compensation data. The authors examined the CFOs’ equity incentives in three settings where prior research had demonstrated an association between CEOs’ equity incentives and earnings management, namely (1) accruals; (2) the likelihood of beating earnings benchmarks; and (3) the likelihood of restatements.

Based on their analysis, the authors conclude that “because CFOs are primarily responsible for preparing the financial statements, the impact of their equity incentives on financial reporting dominates the impact of the CEOs’ equity incentives.” Indeed, the authors conclude that “earnings management is a key tool that the CFO can expertly use to respond to equity incentives.”

Although the paper has a number of interesting insights, perhaps the most interesting is the authors’ analysis of the way that CFOs respond to the prospect of option grants. The authors found that the occurrence of the grant of options to the CFO was positively correlated to the occurrence of an earnings miss (which would lower the option strike price and thus make the grant potentially more valuable). The authors further concluded that “the likelihood of missing earnings benchmarks is higher for stock options granted to the CFO relative to those granted to the CEO and in some cases significantly so.”

One of the fundamental tenets for the compensation of corporate executives is that the executives’ interests should be aligned with those of the shareholders, and that the best way to achieve alignment is through equity-based compensation. The authors’ research suggests, however, that equity-based compensation may not create alignment, but rather motivates earnings management. Indeed, the authors’ research could be read to suggest that the equity-based compensation could create incentives that are contrary to shareholders’ interests, because shareholders obviously have no interest, for example, in engineered misses of earnings estimates.

The authors do conclude that their research underscores the importance of the SEC’s recently adopted provisions requiring disclosure of CFO compensation. This disclosure, the authors state, “should be relevant to users of financial statements in evaluating the quality of firms’ financial reporting.”

Among those to whom the CFO compensation information could be of interest are D&O underwriters. While the authors’ research does not directly make the connection between CFO equity compensation and the incidence of securities lawsuits, the link the authors do establish between CFO equity incentive compensation and earnings management should be sufficient to suggest the relevance of CFO equity compensation for D&O underwriting purposes. If, as the Corporate Library proposes, CEO compensation is an important indicator of securities litigation susceptibility, then the research of these three Michigan State professors could be interpreted to suggest that CFO compensation is also an important indicator, perhaps even more so.

Hat tip to the CFO Blog (here) for the link to the academic research paper.

For Better or Worse – Unless You Wind Up in Jail: This blog does not ordinarily comment on domestic relations issues, but we did fund it noteworthy that, according to news reports (here), former Tyco CEO Dennis Kozlowski was about to reach terms for his divorce from his wife, the former Karen Mayo. Mayo is the former waitress whom Kozlowski married in 2001, and whose $2 million Roman-themed 40^th birthday party on Sardinia that same year ultimately proved to be a key component of Kozlowski’s later criminal trial.

According to news reports, Mayo had request that the couple’s assets be split equally and she also sought alimony. The news reports do not disclose whether Mayo will receive a portion of the $1/day Kozlowski now reportedly receives “mopping floors or slinging hash” to fellow inmates at the New York correctional facility where he is serving a term of between eight years, four months and twenty-five years.

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It is nothing new for corporate America to have to contend with activist investors. But an activist international institutional investor, backed by a sovereign nation and burgeoning oil wealth and committed to a broadly-based social and environmental agenda, represents a different level of activist pressure. The prototype for this international institutional investor is the Norwegian Government Pension Fund, which collects and invests surplus revenue from the country's petroleum production, and which at $300 billion in asset value represents the largest public pension fund in Europe. The Fund is prohibited from investing in Norway, so instead it owns what amounts to a considerable slice of the world.

The Norwegian Fund's impact is not merely financial. The Fund operates according to "ethical" investment principles, pursuant to which the Fund has divested ownership in companies that the Fund's Advisory Council on Ethics believes are involved in certain kinds of weapons production, environmental damage and human rights violations. The most prominent example of its divestitures for ethical reasons was its high profile divestiture of its $400 million investment in Wal-Mart because of alleged child labor law violations by WalMart suppliers (refer here).

A May 4, 2007 New York Times article entitled in the print edition "Norway Backs Its Ethics With Its Cash" (here) discusses the Fund's ethical investing practices and their impact. The article quotes the Norwegian Finance Minister, Kristin Halvorsen, as saying "In a global economy, ownership of companies is the most important way to have influence." As many as 21 companies (so far) have felt this Norwegian "influence," twelve of them American.

Nor is the Fund's activist impact restricted to its investment activities. Norges Bank, the division of the Norwegian Central Bank responsible for managing the Fund's investments, has made its presence felt as a securities fraud lawsuit litigant. For example, Norges Bank was one of the prominent litigants that chose to opt-out of the Time Warner class action settlement (here). Norges Bank was also a major participant in the recent historic Royal Dutch Shell investor settlement (here).

The most prominent institutional investor activist in the U.S. has arguably been the California Public Employee Retirement System (Calpers), which with current investement assets of about $244 billion is actually smaller than the Norwegian Fund. Moreover, because Norway is the world's No. 3 oil exporter (behind Saudi Arabia and Russia), Norway's Fund will grow substantially in the years ahead. The Times article estimates that at the rate at which it is growing, the Fund could be worth $800 billion to $900 billion in a decade. With the Fund's growing size and activist agenda, its impact could be enormous, particularly given the Fund's apparent willingness to resort to litigation.

The Fund's growth will provide it with the powerful tools to drive its agenda. As a result, companies could face growing pressure to provide compliance and disclosure on a broad range of social and environmental issues. Readers of The D & O Diary will recall my recent post (here) on the growing importance of climate change disclosure; the Times article reports that the Norwegian Fund's next area of scrutiny will be companies that contribute to global warming. (There is of course some irony in a country which has grown wealthy from oil production presuming to lecture the rest of the world about global warming.)

The upshot is that public companies could face growing pressure on environmental and social issues, from the Norwegian Fund as well as other investors that follow their lead. Traditional notions of "good corporate governance" will necessarily evolve to adapt to these circumstances. These evolving issues represent risks that may not be apparent on companies' financial statements. Companies will face changing levels of reputational risk and even political risk as part of this evolving global investment dynamic. It will be increasingly important for companies to have tools to measure and control their exposure to these developing concerns, as well as to provide adequate disclosure of these issues to their shareholders.

Cross-Border Prosecutorial Collaboration: Along with the globalization of political and social issues, the increasing global collaboration of national regulatory and investigative personnel also represents a new and growing risk to companies in the global economy. The high-profile collaboration of a multinational investigative force in the Siemens bribery investigation (here) is a recent prominent example. Another example is illustrated in a May 4, 2007 Wall Street Journal article entitled "Cartel Arrests in U.S. Bolster Europe Probe" (here, subscription required).

According to the Journal, executives from companies in Italy, France, the United Kingdom and Japan were arrested in the U.S. this past week for their role in an alleged international cartel to fix prices for industrial hoses used in oil transportation. The arrests reportedly were "the result of a joint U.S. investigation with the European Union and U.K. agencies under a program of trans-Atlantic cooperation against bid rigging." The stumbling block for EU enforcement of its anti-cartel laws has been the lack of any personal liability for cartel participants under EU law. These limitations have restricted EU authorities' ability to pursue cartel activities. The enlistment of American authorities in the anti-cartel efforts circumvents these EU limitations by exposing individuals to personal liability under tougher American anti-cartel laws.

While these developments are perhaps socially desirable for their ability to punish and deter anticompetitive activity, the developments also carry some disturbing implications for officials at companies engaged in the global economy. Executives could face the threat of prosecution not only under the laws of their own country but under the laws of many other countries. The willingness of the U.S. to enforce its antibribery laws against foreign companies whose shares or ADRs trade on U.S. exchanges is another example of this extraterritorial impact of domestic laws. The result of this globalization of criminal enforcement could be a dramatic expansion of corporate executives' risk exposure.

Not only does this evolving globalization of criminal enforcement create a new category of risk management challenges, but it could create new challenges for the structure of the companies' D & O insurance program. Certainly, companies engaged in the global economy will want to understand their policy's potential protection for foreign investigations and proceedings, as well as the policy's protection for criminal processes such as extradition.

Be Here Now: As scientists and commentators have struggled to prefigure a future world beset with the consequences of global climate change, they have projected a litany of grave impacts: coastal erosion and subsidence from rising sea levels; extreme weather events; unprecedented economic impacts; and a deteriorating health environment.

Readers skeptical of these scenarios will want to consider these stories appearing in newspapers just this week alone: the seacoast of East Anglia in the U.K. is sliding into the sea because of rising sea levels (here); Australia's six year drought is now so serious that the country must restrict crop irrigation, while politicians struggle to respond (here); Germany will no longer apply seasonal adjustment to its unemployment statistics because the increasingly mild winters have a diminished employment impact (here); and the global incidence of asthma and hay fever has escalated as a result of the proliferation of allergens due to warming conditions (here).

After I wrote my post a few weeks ago about global climate change and D & O risk (here), I received some very skeptical and even derisive reactions. But the reality is that global climate change is not some distant theoretical construct. Its impacts are already being felt throughout the world. The answer to the question whether or not this will affect the risk profile of publicly traded companies is simply a reflection of the way you frame the issue. You can, as I think is the proper approach, regard global climate change as a separate category of risk to be analyzed as such. Or you can simply look at it as imbedded within numerous other risk categories, such as commodities pricing risk, political risk, and currency risk, as well as what insurers call parameter risk (the risk of events different than those that have occured in the past). Whether viewed separately or as a part of the overall panoply of corporate risk, global climate change will be an increasingly important part of the risk landscape that companies face. The influence of activist investors like the Norwegian Fund suggests that companies disregard these risks at their peril.

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One of the essential tenets of modern corporate governance is that shareholders control corporate managers through shareholder voting. This notion is founded on the premise that shareholders will vote their economic interests, and the weight of their vote will be proportionate to their economic interest. However, research by University of Texas law professors Henry Hu and Bernard Black reveals that as a result of recent capital markets developments, hedge funds and other investors can "decouple" voting rights from economic ownership of shares. For example, a hedge fund borrowing shares from institutional investors can acquire the voting rights of the borrowed shares, even though the shareholder who owns the shares retains the economic interest in the shares.

The professors' legal research can be found here and here, and is discussed in a January 26, 2007 Wall Street Journal article entitled "How Borrowed Shares Swing Company Votes" (here, text courtesy of the Texas Law School web site).

The hedge funds or other investors who wish to obtain voting power do so by borrowing shares from large institutional investors, often as part of a short selling strategy. Borrowing the shares allows the hedge funds to gamble that the shares will decline, and they can use their vote to try to ensure that they will. The professors call the exercise of voting rights divorced from economic interests "empty voting." The Journal article cites several examples where shortselling hedge funds used this technique as part of a successful short selling strategy.

The professors emphasize that no one knows how widespread this practice is. Their research examined 22 instances worldwide from 2001 through 2006. The Journal article notes that these kinds of votes have not yet affected outcomes in many general corporate elections. But the practice could become more important given current corporate governance momentum built around increasing "shareholder democracy," such as the push for majority voting of directos and the right of shareholders to be able to propose board candidates.

The "empty voting" issue has attracted the attention of regulators. SEC Commissioner Paul Atkins, in a speech on January 22, 2007 (here), raised his concerns with the practice, and the Journal article quotes SEC Chairman Christopher Cox as saying that the practice is "almost certainly going to force further regulatory response to ensure that investors' interests are protected."

Finding a simple regulatory solution may be complicated by the fact that shareholder voting is largely controlled by state law. In addition, the vested interests in the status quo include not only hedge funds and others who might use the strategy to advance their interests, but also the institutional investors who profit by lending their shares. According to the Journal, brokerages and big banks now make $8 billion a year in fees they earn by lending their shares. CalPERS alone made $129.4 million by lending shares its holds in the year ending March 31, 2006.

The professors proposed solution puts less emphasis on regulation and more on disclosure. They propose an "integrated ownership disclosure reform," that would require disclosure both of voting and economic ownership. The professors proposed solution would not eliminate some disclosure delays, and even allows the possibility that the disclosure might not take place until after the vote has taken place - but it would still ensure that the disclosure takes place eventually, which would both inform regulators and lawmakers for future remedial purposes, and act as some constraint on behavior.

An interesting perspective on this issue, and a presentation of the brief against further regulation on this issue, can be found on Professor Larry Ribstein's Ideoblog, here. CFO.com also has an interesting January 26, 2007 article entitle "How to Beat the Hedge Fund Bullies" (here), that examines strategies that companies can use to identify who their shareholders are and analyze how the shareholders' are voting.

SEC Chairman Cox on Global Competitiveness: As The D & O Diary has noted on numerous recent posts (most recently here), the issue of the competitiveness of the U.S securities markets in the global economy has been the subject of a great deal of comment lately. Regular readers will recall my concern that while the U.S. should look to its competitive interests, it should take care to avoid compromising its regulatory integrity. In a January 24, 2007 speech (here), SEC Chair Christopher Cox added the following perspective on the threats to the competitiveness of the U. S. markets:

The threat comes not from fear of foreign competition, or foreign issuers, or foreign investors. Both competition, and the influx of foreign capital and issuers, promise only good for our markets. Rather, the threat comes from the increasing opportunities for fraud, unethical trading practices, and market manipulation that globalization brings with it. Just as investors and issuers can more easily seek each other out around the world, those with less honorable intentions can also reach across borders, to prey upon distant investors. And when they succeed, they damage confidence in all of our markets.

As the proposals for regulatory reform continue to emerge in the coming months, it will be important for us to remember what kind of investors and what kind of investment activity we do and do not want to attract to U.S. securities markets.

Tellabs Goes to SCOTUS: On January 5, 2007, the U. S. Supreme Court granted certiorari (here) in the Tellabs case on the issue of the standard for pleading scienter under the Private Securities Litigation Reform Act of 1995 in securities fraud suits. An excellent brief summary of the issues involved in the case written by Jonathan Jacobs of the Wiley Rein firm can be found here.

Best in Class: Those readers who, like The D & O Diary, were fans of the late, lamented Securities Litigation Watch blog will be delighted to learn that its author Bruce Carton has launched a new blog, Best in Class, which can be found here. The early posts suggest that the new blog will be as timely and informative as the SLW.

Readers will also be interested to know that Bruce will be hosting a webcast on Tuesday January 30, 2007 at 1:00 p.m. EST on "Emerging Trends in Securities Class Actions."

Hat tip to the 10b-5 Daily Blog for the information about Best in Class.

Next week: I will be in New York next week for the PLUS D & O Symposium (here). I hope that readers of The D & O Diary will please say hello to me during the Symposium and let me know what they think of the blog. See you all in New York.

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According to an article in the January/February 2007 issue of Corporate Board Member entitled "Is Your Company Prepared for Bird Flu?" (here), boards should be anticipating and preparing for the potential impact of a bird flu pandemic. The article quotes former Secretary of Health and Human Services Tommy Thompson as saying that smart boards are preparing now, by reviewing contingency plans and establishing lines of authority in the event company leadership is stricken by the bird flu. The article does acknowledge that "[s]ome directors privately conceded that little attention is being paid to the specific challenges posed by a pandemic."

As someone who has spend the better part of my professional career thinking and worrying about board focus and function, I have to admit that under the current circumstances I have a hard time seeing bird flu as belonging anywhere the top of the list of things boards at most companies are or ought to be worrying about. Along those lines, the article does contain the following:

Damian Brew, a managing director with Marsh's professional-liability practice, says the risk of a pandemic pales against other exposures, including oil-price fluctuations, and adds that underwriters of directors' and officers' liability coverage are more concerned with options backdating and CEO pay disclosure. "Boards have a limited amount of time, and there are financial issues that should take priority over something that's not likely to happen," he says.

I agree with these statements. But the article goes on assert that boards that fail to plan for a bird flu pandemic "could find themselves targeted for dereliction of duty." The article quotes one attorney as saying that Sarbanes-Oxley requires boards to take into account almost every conceivable problem that could put the company in jeopardy. The article quote another attorney as saying that "If the business has trouble functioning, you could have shareholders saying 'Why wasn't there a plan in place?' You aren't going to be able to say you hadn't heard about it."

Undoubtedly boards could allocate a portion of their scarce time together to worry about bird flu. They could also spend time worrying about global warming, land use policy, plate tectonics and its implication for seismic and volcanic activity, and the hole in the ozone layer. There are a limitless number of things that boards conceivably could spend their time on. At some point though, boards have to be focused on whether the company is on the right track, has the right management in place, or needs to make strategic changes. There undoubtedly are risks in every company's environment, and boards should of course take reasonable steps to ensure that the company has a flexible catastrophe plan in place and that the plan adequately addresses the specific risks to which the particular company may most likely be prone. There are many threats facing companies today. Boards are doing their job best if they focus on the threats and opportunities that matter most immediately for their company.

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One of the great things about having a blog is that it has brought me into contact with a host of people I might otherwise never have gotten to know. Among the most interesting and colorful people I have met through my blog is Sammy Antar, Crazy Eddie's cousin, and the author of the White Collar Crime blog (here). Regular readers will recall my recent post referring to Sammy and his views, here. As a result of my post, Sammy called me up and we had a great conversation about a number of things, including D & O insurance. Among other things, Sammy wondered why D & O insurers don't condition their coverage on certain remedial or preventive measures, the way bank lenders require covenants on their loans or property insurers require for their policies.

Sammy's question is one I have encountered again and again from thoughtful people outside the D & O insurance industry. A more scholarly example of this perennial question is presented in the November 17, 2006 law review article entitled "The Missing Monitor in Corporate Governance: The Directors' and Officers' Liability Insurer," (here) written by Professors Tom Baker of the University of Connecticut Law School and Sean Griffith of the Fordham Law School (here). Baker and Griffith's well-researched, well-written, thoughtful and thought-provoking article examines the same question that Sammy Antar posed to me: why don't D & O insurers perform more of a corporate governance monitoring function?

The authors recognize the role D & O insurers theoretically might now be playing by offering lower priced insurance to companies with better governance practices. However, as the authors also recognize, competitive pressures and insurers' zeal for premium volume limit carriers' price differentiating ability and undercut the role insurance cost might otherwise play in motivating behavior. I would add that factors unrelated to governance, such as a company's size or industry, are almost always more important pricing criteria, and so even in ideal circumstances, D & O insurance pricing would provide at best a weak incentive to corporate governance behavior. In addition, for most companies during most phases of the insurance cycle, the relatively minor variations in their D & O insurance costs are unlikely to have any impact on corporate governance behavior because the dollars involved are too slight.

The authors then look at whether D & O insurers are affirmatively offering loss prevention services, the way many property or workers' compensation insurers do. The authors conducted extensive empirical research by interviewing many underwriters, brokers and risk managers. Their empirical research showed that despite logical incentives for them to do so, D & O insurers do not affirmatively provide or offer their insureds loss prevention services. (Full disclosure: I was among the insurance industry representatives the authors interviewed as part of their empirical research.) Not only that, the authors found that D & O insurers don't even manage claims that arise under their policies, but rather allow their insureds to select defense counsel and manage the defense, in a way that leaves defense expense essentially uncontrolled. The authors conclude that the D & O insurers' failure to provide loss prevention services and to manage claims allows management conduct to continue without the checking function the insurer might provide. In addition, because most D & O claims settle within the limits of the D & O insurance, company management is permitted to shift all of the consequences of their behavior away from themselves.

The authors examine the purpose and impact of D & O insurance under these circumstances and conclude that companies continue to buy D & O insurance because it provides company officials with a corporately-financed way for management to protect themselves from their own liability exposure without the requirements of any constraints on their behavior. The authors conclude that affairs are arranged this way because it suits corporate managers, who are free to indulge in risky behavior secure in the belief that their D & O insurance will protect them and their company if there are any problems. The authors question whether shareholders' interests are served by this arrangement, and whether the existence of D & O insurance (or at least corporate reimbursement and entity coverage) creates a moral hazard by insulating companies and their managers from the consequences of their behavior.

Readers familiar with my professional history know that I am perhaps uniquely qualified to comment on the reasons why D & O insurers do not offer loss prevention services. My curriculum vitae includes an extended deployment as the head of a D & O facility that was founded on the optimistic premise that a D & O insurer ought to provide loss prevention services and that offering those services would be a competitive advantage. This noble experiment died a death of many causes, and having presided over the enterprise's life span, I can authoritatively recite here why D & O insurers do not offer loss prevention services, as follows:

1. Everybody Has to Do It or Nobody Can Do It: Corporate insurance buyers want their acquisition of D & O insurance to be as uncomplicated and consume as little time as possible. Even if a D & O insurer is offering free services that will help improve their company's risk profile, the company's managment will not desire the services if the services take additional time and attention. As long as there is one competitor anywhere who will offer the same coverage (at least at the same or similar cost, more about which below) without requiring the company to "jump through hoops," the free services will go unclaimed. Of course, this is not universally true, there are some companies that will value the service, and there are other companies who could learn to appreciate the value of the services. More about these kinds of companies below.

2. Even if the Services Are Very High Quality, They Will be Undervalued in the Marketplace: Unfortunately, insurance companies are not held in the highest regard in corporate America. Too many companies view their D & O carriers with suspicion or even hostility. To be sure, there are some companies who welcome their D & O insurers' views about corporate governance, but not enough to make the costs of providing the services economically self-sustaining. Corporate management's suspicious views of their D & O insurers may be encouraged by the their outside counsel. While some lawyers (and I was always proud that it was the best lawyers) welcomed the provision of high quality loss prevention services, there were other lawyers who viewed an insurer's provision of these services as a competitive threat for services the lawyers themselves wanted to provide or as some clever ruse to permit the insurer to deny coverage later.

3. The D & O Pricing Environment Does Not Support the Pricing Premise: Some companies might want their D & O insurer's loss prevention services but not if their companies have to pay for the services. It might be possible for a D & O insurer to insist on corporate governance reforms if the insurer could offer demonstrable insurance cost savings for qualifying companies, but the reality is that the D & O insurance sector has been and remains so competitive that it is impossible to show cost savings. There is always a competitor willing to offer the same or similar coverage at the same (or better) discount, and so companies who might otherwise accept their insurer's loss prevention requirements have little monetary incentive to do so.

4. Loss Prevention Services Are Costly To Provide and Maintain: For a D & O insurer to plausibly offer credible loss prevention services recognized as valuable by senior corporate executives , the insurer has to be willing to make and sustain a very significant investment in high quality personnel. However, top management at insurance companies, who rarely have background in D & O insurance but rather are drawn from more mainstream property or casualty insurance backgrounds, and who view the business of insurance as a high volume low skill enterprise, have little appreciation for or patience with the need for this kind of investment. These kinds of expenses do put significant pressure on operating margins, and indeed ultimately may not be economically justifiable given the pricing environment that has prevailed in the D & O insurance industry for almost all of the last 20 years (except for a very brief period during 2002-03).

5. D & O Loss Prevention Has Less Certain Benefits than A Sprinkler System Does: A sprinkler's system's benefit is direct and easily understood. Good corporate governance may or may not have as direct of a benefit. Baker and Griffith seem to assume that loss prevention can improve companies and reduce their securities litigation risk. I still believe this to be true, but at the same time I have to acknowledge that a company can do everything right and still get sued. So many of the major D & O claims problems of the last few years have come from unexpected directions. Sector slides, industry contagions, practices that are widespread and accepted that suddenly become perceived as objectionable, these are all phenomena that caused boatloads of D & O losses in recent years that no amount of loss prevention would have prevented.

I could go on and on about the reasons D & O insurers don't offer loss prevention services. (Buy me a few beers sometime and I will keep it going for hours.) In fact, Baker and Griffith mention in their article a few additional factors that I did not even get to here. But I think I have shown that there are many reasons why D & O insurers do not provide these services. This fact may be lamentable, but unless circumstances change dramatically in ways I do not anticipate, this is just the way things are and seemingly will remain in the D & O insurance industry.

That said, I cannot support the Professors' conclusion that D & O insurance as it is currently purchased by most companies is a moral hazard. This particular topic is well beyond the scope of the informal blog format, but I will briefly offer my views for disagreeing with the Professors.

It is extremely unlikely that the presence of D & O insurance operates as any kind of an enabler of bad behavior: I flatter my chosen field by thinking that D & O insurance is pretty important stuff, but I am realistic enough to understand that corporate managers conduct their operations in a way that they think is either in the company's or their own best interests without regard to their D & O insurance. They don't stop before taking an action and reflect that they wouldn't do it if they didn't have D & O insurance. I view it as an extremely remote and unlikely theoretical possibility that corporate managers do anything they wouldn't otherwise do because their company has D & O insurance.

Corporate Managers Worry More About Potential Consequences For Which There is No Insurance: Corporate managers know that the same kind of conduct can attract the unwanted attention of plaintiffs' lawyers can also attract the unwanted attention of the SEC and the Department of Justice. Even if D & O insurance were to cease to exist as an earthly phenomenon tomorrow, most senior officials' conduct would go on exactly as before (that is, equally as good or bad as before) because the admonitory threat of the regulators' actions would remain as before. That is, because of the threat of regulatory action, the theoretical possibility that D & O insurance might otherwise operate as a moral hazard simply doesn't exist.

Most Corporate Managers Truly Want to Do the Right Thing: There are crooks out there; my comments here don't apply to them. In my experience, most corporate managers are interested in playing by the rules, and more importantly, for being known for playing by the rules. The idea of seeing their name in the paper as accused of fraud is absolutely mortifying. The fact that there might be insurance to eliminate the monetary inconvenience of a securities fraud lawsuit is irrelevant to their desire to avoid the kind of reputational taint that might follow an accusation of fraud, even if the accusation were merely to be made by plaintiffs' lawyers.

Because I truly believe that almost all corporate officials want to do the right thing, I think there may yet be a role for loss prevention services in the D & O insurance equation. I am an eternal optimist, and I continue to believe that high quality loss prevention services will be valued by some companies and ought to be valued by all companies. I also believe that D & O insurance professionals can and ought to offer these services.

It may be that competitive forces between and among D & O insurers will discourage the insurers from carrying the experiment forward. Brokers, by contrast to insurers, are in the business of providing consultative services, and for that reason I believe that highly qualified brokers could offer loss prevention services to their D & O clients. Baker and Griffith looked briefly as what the past practices may have been as far as brokers offering these kinds of services and concluded that brokers are not offering these services. My recent entry into a new livelihood as a D & O broker is premised on the possibility that brokers have a role to play here. I have experience in this area, after all. Anybody that wants to talk to me about it should give me a call -- I have already had a great telephone conversation with Sammy Antar about it.

Hat tip to Adam Savett at the Lies, Damned Lies blog (here) for the link to Professors Baker and Griffith's law review article.

A prior D & O Diary post commenting on an earlier article by Professors Baker and Griffith can be found here.

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Within the last few days, we have witnessed the feuding, dysfunctional H-P Board struggling with the turmoil and adverse publicity arising from its flawed investigation of media leaks. Last week we also saw the forced ouster of Bristol Myers Squibb CEO Peter Dolan. These events follow the removal of the CEOs of some of the country's largest companies, including Walt Disney, Fannie Mae, Pfizer, American International Group, Merck, and others. These events not only involve the potential for board turmoil, distraction and adverse publicity, but increasingly also present the possibility of D & O litigation.

For example, late last week, Bill Lerach of the Lerach Coughlin firm filed a shareholders' derivative suit against the H-P Board, accusing the Board (and its general counsel, as well as it purported outside investigative service) of breaches of fiduciary duties, abuse of control and waste of corporate assets, as part of an alleged campaign to entrench themselves and to punish or diminish the power of ousted directors. A copy of the complaint can be found here. The lawsuit not only seeks corporate remediation, but also seeks recovery for the "enormous" costs and burdens the company has sustained to deal with the crisis created by the revelations of the Board's investigation. Significantly, the complaint against the H-P directors seeks to compel the recovery from the defendants of the company's costs without their recourse to indemnity or insurance, even for the costs of defending the derivative litigation. A September 15, 2006 Law.com article discussing the H-P complaint can be found here.

Nor is H-P's situation the only boardroom dispute that has resulted in D & O litigation. For example, at Atmel, five independent board members (representing private equity fund investors) worked together to bring about the August 5 firing of company founder and CEO George Perlegos, as well as three other executives, for alleged misuse of corporate travel funds. Perlegos responded by filing a lawsuit against the board, arguing that his ouster was illegal because he had already called a shareholder meeting in order to remove the five independent directors. His lawsuit argues the directors should be removed because "the hasty, secretive, and precipitous manner in which they acted...will have devastating consequences for the Company, including but not limited to the loss of the [ousted executives'] decades of experience running the company and a significant loss of shareholder value." News report discussing the Atmel litigation can be found here and here.

These boardroom disputes and the others identified above are a result of a variety of factors. The increased presence and activism of independent directors, who are less inclined to take their cues from company management, is a direct result of Sarbanes-Oxley reforms and is clearly a factor in the newly contentious board environment. Regulatory and investigative pressures are also important factors. For example, the removal of AIG's and Bristol Myers Squibb's CEOs were a direct result of investigative pressures. Increased shareholder activism, including the pressure of activist hedge funds and other private equity investors, also is a contributing factor. (For a prior D & O Diary posts discussing the litigation threat of activist hedge funds, click here and here.)

All of these factors are contributing to an increasingly hostile boardroom atmosphere. This atmosphere not only presents a challenge for corporate boards, but also represents an environment where allegations of wrongdoing can more easily arise. These allegations of wrongdoing inevitably will make their way into the courtroom, and so the newly contentious boardroom environment represents a potentially significant source of increased D & O claims exposure.

On Saturday, September 16, 2006, articles appeared in Wall Street Journal (here, subscription required) and in the Washington Post (here, registration required) discussing the new hostile environment for corporate boards.

Silicon Valley Connection: The shareholders' derivative complaint filed against the H-P Board take particular aim at the Board's continued reliance on the outside counsel, the Wilson Sonsini law firm, on whose advice the company relied in connection with the investigation, the board disputes arising out of the investigation, and the company's disclosure of the investigation and the board's disputes:

[E]ven though they were facing a matter with grave implications for the corporation, [the Board] did not seek independent legal representation or advice. Worse yet, they actually relied on the advice of the law firm that was implicated in the conduct to be evaluated. Because Sonsini of Wilson Sonsini had been intimately involved in advising the Board and its Chair regarding the investigation that had taken place, the law firm knew or should have known of the dubious legality of the investigatory tactics being used and yet had advised the Board ...that the investigatory tactics being used were not unlawful and advised HP to not disclose why [Perkins, a Board member who resigned, had actually resigned.]

The Complaint goes on to allege that a demand upon the Board to bring legal action would be futile because "Wilson Sonsini and Sonsini continue to be the primary outside counsel for the Company regarding these matters and obviously, since Wilson Sonsini and Sonsini are conflicted and would be key witnesses and possible defendants in any ultimate legal action, they will advise the Company not to pursue legal action or conduct a vigorous independent investigation into matters that will embarrass the law firm, further implicate the law firm, or expose the law firm to financial liability."

Nor is the H-P lawsuit the only source of legal scrutiny facing the Wilson Sonsini firm from the H-P board investigation. According to news reports (here and here), Larry Sonsini is among the witnesses requested to appear to testify before a Congressional panel looking into the H-P board's investigation of media leaks. The Oversight and Investigations Subcommittee of the House Committee on Energy and Commerce will be holding September 28, 2006 hearings on the matter. Several witnesses, including Sonsini, have been sent letters requesting them to notify the committee on or before September 19, 2006, whether they will appear voluntarily. The attorney-client privilege and Fifth Amendment privilege issues that this congressional investigation might present are discussed in this post on the White Collar Crime Prof blog, here. The WSJ.com law blog also has an interesting post here discussing the swirl of activity surrounding Sonsini.

The H-P derivative lawsuit is far from the only salvo that Lerach has launched against the Wilson Sonsini firm recently. As noted in a prior D & O Diary post (here), Lerach has opposed efforts to dismiss the shareholders' derivative suit pending against Mercury Interactive based on an alleged conflict of the Wilson Sonsini firm -- Wilson Sonsini represents one of the defendants in the Mercury Interactive suit, and is also outside counsel for H-P, which is acquiring Mercury Interactive.

When asked who he thinks will defend the H-P Board in the shareholders' derivative suit he filed, Lerach responded that "I bet it won't be Wilson Sonsini."

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Along with the burgeoning growth of the hedge fund industry has come the increasing importance and influence of activist hedge funds. This activism has taken a variety of forms, from public pressure on portfolio companies to change business strategy, to the running of a proxy contest to gain seats on the boards of directors of portfolio companies, to litigation against present or former managers.

This increase in hedge fund activism has attracted sharp criticism. Martin Lipton of the Wachtell Lipton law firm lists "attacks by activist hedge funds" as the number one key issue for directors. He has issued a series of client memos (here, here, and here) advising companies how to prepare to fend off hedge fund attacks. He characterizes the activist hedge funds as "self-seeking, short-term speculators looking for a quick profit at the expense of the company and its long-term value." Lipton has been a vociferous advocate for greater regulatory supervision of hedge funds.

A July 2006 research paper (here) written by New York University law professor Marcel Kahan and University of Pennsylvania law professor Edward Rock, entitled "Hedge Funds in Corporate Governance and Control," takes a comprehensive look at hedge funds' impact on corporate governance. The article is replete with specific, heavily-footnoted examples of activist hedge funds' corporate governance activities. In general, the authors regard activist hedge funds' role in corporate governance as positive, and one that hedge funds are favorable position to play because of their investment approach and freedom from regulatory oversight. One particularly colorful example the authors examine involves Third Point LLC's criticism of Star Gas's CEO Irik Sevin, to whom Third Point wrote:

It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites....We wonder under what theory of corporate governance does one's mom sit on a Company board. Should you be found derelict in the performance of your executives duties, as we believe is the case, we do not believe your mom is the right person to fire you from your job.

Bowing to Third Point's pressure, Sevin resigned one month later.

While the authors contend that hedge funds have unique incentives and advantages that better position them (compared to other institutional investors) to address corporate governance issues, they do acknowledge that activist hedge funds' actions can raise certain concerns. First, hedge funds' interests can diverge from those of fellow shareholders, as, for example when a hedge fund is a potential buyer of a company in which it has a stake. Second, with billions of dollars of assets, hedge funds put stress on existing corporate governance structures, as, for example, when loose hedge-fund coalitions target a shareholder vote. The authors acknowledge these concerns, but find them no worse than concerns surrounding other institutional investors, and argue that these concerns are not sufficient to justify greater hedge fund regulation.

The most serious criticism of hedge fund activism, the one Marty Lipton raised, is that hedge funds exacerbate short-termism. The authors argue that the market will enforce adaptive approaches to deal with the potential negative effects of hedge fund short-termism. The authors cite Lipton's own "Hedge Fund Attack Response Checklist" as an example of just such an adaptive device, about which the authors state:

[Lipton's suggestions] are terrific ideas, not just to deal with activist hedge funds but in general. If companies follow Lipton's advice, hedge funds will have already made significant positive contributions to the management of U.S. companies. Moreover, if hedge funds can succeed despite companies taking these measures, we think chances are reasonably high that they have a good point.

The authors' conclusion is that "market forces and adaptive devices take by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation."

The increasing influence of activist hedge funds has important implications for D & O risk. Specifically, activist hedge funds' corporate governance activities can involve litigation, including litigation directed against directors and officers. A prominent recent example is Cardinal Value Equity Funds' litigation campaign involving Hollinger International and allegations of Conrad Black's self-dealing and other transactions, which culminated in a derivative lawsuit for breach of fiduciary duty against Hollinger's board of directors. After an independent Board committee investigation, Cardinal negotiated a $50 million settlement with the directors not directly implicated in the self-dealing. The settlement was funded by Hollinger's D & O insurers. (Hollinger's press release may be found here. )

Hedge funds have even sought appointment as lead plaintiffs in securities fraud lawsuits. Indeed hedge funds often are the investors with the largest losses, but because they often engage in short-selling, they may be subject to unique "reliance" issues and therefore many not be "adequate" class representatives. For that reason, courts have often, though not uniformly, rejected the appointment of hedge funds as lead plaintiffs.

But because activist hedge funds view litigation as an essential part of their activist strategy, the role of hedge funds as "the prime corporate governance and control activists" has very important implications for D & O risk. While hedge funds' activism potentially could contribute to improved corporate governance, the willingness of hedge funds to achieve their goals through litigation against directors and officers represents a dangerous variation of D & O exposure. Marty Lipton may not have been far off the mark when he described the threat of activist hedge funds as the most important issue for corporate officials.

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Eliminate Quarterly Guidance? On July 24, 2006, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics issued a Report entitled "Breaking the Short-Term Cycle: Discussion and Recommendations on How Corporate Leaders, Asset Managers, Investers and Analysts Can Refocus on Long-Term Value," calling on corporate leaders, asset managers and others to break the "short-term" obsession and reform practices involving earning guidance, compensation and communication to investors.

The report is the product of a series of symposia the groups co-sponsored to address issues of "short-termism." The symposia participants included a number of widely respected individuals, including John Bogle of the Vanguard Group, Louis Thompson of the National Investor Relations Institute, and other representatives from companies, investor groups and securities analyst firms.

The report states that "the obsession with short term results by investors, asset management firms, and corporate managers collectively leads to the un-intended consequences of destroying long-term value."

The report's recommendations include the following actions:

• End the practice of providing quarterly earnings guidance;
• Align corporate executive compensation with long-term goals and strategies and with long-term shareholder interests;
• Improve disclosure of asset managers' incentive metrics, fee structures, and personal ownership of funds they manage; and
• Endorse the use of corporate long-term investment statements to shareowners that will clearly explain - beyond the requirements that are now an accepted practice - the company's operating model.

With respect to quarterly earning guidance, the report notes the following:

Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a "quarterly results" financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets.

A prior D & O Diary post noted that these and other concerns increasingly are motivating companies to move toward annual earning guidance only or the elimination of earnings guidance altogether. The elimination of quarterly earning guidance would not only address the concerns noted in the recent Report, but also would discourage activity that frequently is at the center of shareholders' claims against companies and their boards. The drive to make (or avoid missing) guidance is the root cause of many of the behaviors that drive shareholders' claims. The D & O Diary believes that implementation of the Report's recommendations for companies -- especially the Report's recommendation about eliminating quarterly earnings guidance -- would be an important step for any company that is serious about managing its securities litigation risk.

The groups' press release describing the Report can be found here. A summary of the Report's recommendations can be found here. A July 25, 2006 cfo.com post discussing the report can be found here. An AAO Weblog post on the report can be found here.

Stanford Clearinghouse Mid-Year Report: On July 26, 2006, the Stanford Class Action Clearinghouse, in conjunction with Cornerstone Research, released their 2006 Mid-Year Class Action Securities Fraud Class-Action Filings Report, which can be found here. The report notes that the 61 class actions filed in the first half of 2006 represents a 45 percent decrease compared to the 111 filings observed in the first half of 2005. The 2006 mid-year numbers represent the lowest level of filing activity during a six-month period since 1996, just after the adoption of the PSLRA. The Report speculates that the decline is due to the passage of time from the Internet bubble of the late 1990s; to possible improvements to corporate governance owing to Sarbanes Oxley; and the overall absence of volatility in stock prices during recent periods. The press release that accompanies the report includes a quotation from a Cornerstone official that "[a]lthough there is no doubt that there has been a considerably lower level of filing activity over the last year, it is still too early to tell whether this is a permanent shift."

The D & O Diary agrees that it is way too early to conclude that the YTD numbers represent a fundamental change. Among other things that the D & O Diary thinks could still produce an uptick in class action securites activity this year is the options backdating scandal and the slow dissolution of the Milberg Weiss firm. Although the options backdating scandal has only produced limited class action securities litigation so far (as the Cornerstone mid-year Report duly notes), the string on the scandal still has a long way to run. The gradual out-migration of Milberg lawyers, including the spawn of new law firms, as well as the attraction of existing plaintiffs' firms (including firms traditionally associated with tobacco or asbetos litigation) to Milberg's space, create a population of plaintiffs' firms and attorneys that need to justify their existence. In addition, market causes, such as the low share price volatility, can change. Rising interest rates and energy prices, war in the Middle East, and the threat of terrorism and natural catastrophes all present the potential to generate volatility and undermine the generally stable business environment we have enjoyed for several good years.

The D & O Diary also notes that the class action securities lawsuits may not even be the shareholders litigation story for the first half of 2006. The real story may be the raft of shareholders' derivative suits that the options backdating scandal has generated (up to 49 cases at last count.)

State of the D & O Marketplace: On July 17, 2006, Advisen released its "Commercial Lines Expert Witness Report for D & O" which surveys the current state of play in the D & O insurance marketplace. The report contains the comments from 14 "thought leaders" in the D & O arena (including underwriters, reinsurers, brokers and attorneys). The commentators share their views on trends in D & O pricing and terms and conditions; the impact of the options backdating scandal and of Sarbanes Oxley on the D & O marketplace; and legal developments that the experts are following. The Advisen Report is a little repetitive, but there are a few nuggets that reward close reading, particularly with respect to policy terms and to legal trends. The comments of several underwriters that D & O pricing will (or at least should) rise in the second half of 2006 appear problematic in light of the statistics in the Cornerstone Report. The Advisen Report can be found here.

Some Healthy Options Backdating Skepticism: As observers and commentators have tried to get a handle on how widespread the options backdating scandal is, some pretty large numbers have gotten thrown around. For example, Professor Erik Lie and Randall Heron's latest study concludes that over 2,200 companies backdated options. Comes now Broc Romanek of the CorporateCounsel.net blog who solemnly declares in this July 24, 2006 post that "[m]y gut tells me there is something fishy" about these numbers. The basis for Romanek's skepticism is a fundamental disbelief that that many people are lying, coupled with a informed belief that many companies have already verified that their companies do not have a problem. Whether or not Romanek's gut is more reliable than Professors Lie's and Heron's analysis is for others to decide, but Romanek does have a point. The sheer magnitude of the Professors' numbers do create credibility tension. If the whole Y2K fiasco taught us nothing else, it surely taught us to be suspicious when the experts are announcing the arrival of Armageddon.

Head Case Redux: As a service to those for whom the Zidane head-butt controversy was the biggest story so far this year, The D & O Diary includes this link to a July 25, 2006 USA Today article (with video footage) entitled "Jockey apologizes for head-butting horse." (I am not making this up.) The jockey is sorry and assures everyone that this "will never happen again." I am sure the horse feels a lot better better about it now with that reassurance. The D & O Diary notes that, unlike Zidane, the jockey was wearing a helmet at the time of the head-butt. Is The D & O Diary the only one puzzled why anyone would ever use their head (which has numerous other important uses) as a weapon?

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One of the least understood and least studied features of the world of corporate and securities law is the impact that directors' and officers' liability insurance has on companies' conduct. A new article by two University of Connecticut Law School professors, Tom Baker and Sean Griffith, represents an ambitious attempt to understand the impact of D & O insurance on corporate governance. The article, entitled "Predicting Corporate Governance Risk: Evidence from the Directors' and Officers' Liability Insurance Market" presents the authors' theory that D & O insurance provides a deterrence function within corporate governance and securities law by forcing worse-governed firms to pay higher premiums than better-governed firms. Because the authors joined their analysis to detailed interviews of key players in the D & O insurance industry, the article does a praiseworthy job describing the industry and the broad outlines of the D & O underwriting process. The article's insights into the D & O underwriting process alone reward close reading.

However, The D & O Diary questions the article's authors' premise concerning D & O insurance underwriters' ability to accurately segment securities litigation risk based upon the underwriters' assessment of various companies' corporate governance practices. The premise derives from some underwriters' own statements of their belief in their ability to differentiate "deep governance" variables such as "culture" and "character." Some underwriters may well believe they have those differentiation capabilities, but the reality is that D & O underwriters necessarily have only limited and brief access to senior company management and rarely see management engaged in unrehearsed activity. Underwriters who believe they truly can discern culture and character on this necessarily limited basis are, in reality, doing little more than their version of Johnny Carson's old Carnac the Magnificent routine, without the humor (or, one hopes, without the costume). In addition, even if D & O insurance rates may be adjusted at the margins for governance factors, the rates themselves are largely driven by the insurance cycle, which for most companies is a much more important factor than corporate governance practices in determining the ultimate price that the companies will pay for its D & O insurance. Because of the impact of the cycle and the level of competition within the D & O insurance industry, it would be difficult to quantify any cost savings a company could realize through better corporate governance. Because the financial link between premium levels and governance practices is so indeterminate, the deterrence role of D & O insurance in corporate governance is theoretical at best. Finally, The D & O Diary questions whether D & O insurance premiums alone could be sufficient to perform the significant role that the article's authors postulate; for most companies, their D & O insurance premium is just another cost of doing business. Companies who can be persuaded to improve their corporate governance practices will do so out of fear of litigation or of government regulators, or because they simply want to do the right thing; the expectations or requirements of D & O underwriters, by comparison, are unlikely to be as important --with all due respect to my many good friends in the D & O underwriting community. (In fairness to the article's authors, the D & O Diary acknowledges that the article recognizes all of the considerations raised in this post; the article simply draws different conclusions. )

All of these concerns notwithstanding, the article does represent an unprecedented and important academic attempt to understand how D & O insurance really works, and in particular, the article's authors' methodology of developing a deeper understanding of the D & O insurance industry through interviews with industry professionals represents an important academic innovation. The D & O Diary suggests that this methodology could very productively be used to develop a better understanding of the true role of D & O insurance in the settlement of shareholders' securities fraud claims.

Full disclosure: the author of The D & O Diary was interviewed by one of article's authors in connection with the empirical research on which their article is based.

A tip of the hat to Adam Savett of the Lies, Damned Lies blog for providing a link to the article.

Aux Armes, Citoyens! Formez Vos Bataillons! Given the level of media coverage, it is hardly surprising that plaintiffs' lawyers have sought to secure their place in the options backdating litigation battlefield by announcing, for example, that they have formed an "Options Backdating Investigation Division", or that they are investigating 48 different companies or "over 50 companies." Perhaps inevitably, the first entrant from the defense bar into this escalating press release arms race has now appeared. On July 10, 2006, the Proskauer Rose law firm announced that it has formed a "Stock Options Task Force," which, their press release explains, is a special multidisciplinary group of over 20 lawyers that will work with companies on stock option timing issues. None of this is surprising to The D & O Diary, since I predicted in my very first post on options backdating that the issue would be "this year's model" of the Lawyers' Relief Act.

In a much more ominous development on the options backdating front, Kevin Ryan, U. S. Attorney's Office in San Francisco announced on July 13, 2006 that his office has formed its own stock options backdating task force. The team is responsible for investigating companies and individuals in Northern California who retroactively changed the dates of stock options with the intent to defraud. According to this post in the wsj.com law blog, the Mr. Ryan's office's press release stated that the task force "will bring criminal charge when appropriate."

Head Case: On the theory that anything that is the subject of a front page article in the Wall Street Journal (subscription required) is a suitable topic for this Internet weblog, The D & O Diary has decided to weigh in on the Zidane head butt controversy -- possibly the only story this year that has gotten more widespread media coverage than options backdating. First, we would like to introduce as Defense Exhibit No. 1 the following link to an extensive video portfolio of the misbehavior of Marco Materazzi on prior occasions, which may explain what may have preceded Zidane's now infamous head butt of Signore Materazzi. Second, in the interests of world peace and understanding, The D & O Diary would like to introduce as Defense Exhibit No.2 the following link as proof that there are a lot of people out there with a lot of time on their hands to exploit the humor in any situation, even the video footage of Monsieur Zidane's head butt. (Does anyone remember who won the game?)

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