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

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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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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One of the propositions on which most commentators seem to agree is that perverse compensation incentives helped fuel the global economic crisis. For example, last Wednesday, formed Fed Chairman Paul Volcker said in a speech that one of the causes of the financial crisis "was the ultimately explosive combination of compensation practices that provided enormous incentives to take risk." Other commentators have made similar assertions.

Given these sentiments, it comes as no surprise that among the first reform initiatives to emerge in the wake of the economic crisis are proposals to regulate compensation practices.

The most attention-grabbing example of this compensation-related reform agenda is last week’s news that the Federal Reserve is planning to issue bank compensation rules that would, according to the Wall Street Journal (here), "inject government regulators deep into compensation decisions traditionally reserved for the banks’ corporate boards and executives." Under this plan, the Fed would review – and could reject or amend – any compensation policies to make sure they "don’t create harmful incentives."

If these reforms are enacted, they could represent a significant potential expansion of bank board liability exposures. As reflected in a September 19, 2009 Wall Street Journal article entitled "Boards Face Expanded Responsibilities" (here), the proposed Fed rules "could increase time demands, recruitment challenges and legal exposures for boards."

Because the proposed Fed plan could lead to the Fed’s review of compensation for "many lower-level employees, such as big traders and groups of loan officers," the plan could "force directors to scrutinize pay practices for more employees," as "board members might have to keep tabs on pay arrangement for thousands of employees."

The Fed plan is not the only reform initiative that could impose increased compensation-related burdens on corporate boards. As detailed in a September 17, 2009 memorandum from the Pillsbury Winthrop Shaw Pittman law firm entitled "Executive Pay Reform Poses Complex Risks for Compensation Committees" (here), there are a variety of legislative proposals now working their way through Congress that could impose increased compensation-related burdens on corporate boards.

Of particular interest here is H.R. 3269, The Corporate and Financial Institution Compensation Fairness Act of 2009, which passed the House on July 31, 2009, and has now moved to the Senate for further review and possible amendment. According to the law firm memo, the Senate is likely to address the Act before the end of the year.

As described in the legal memo, the Act among other things embodies the principle that "the process of establishing executive compensation schemes should be transparent, protect against bias and provide enhanced accountability." The memo goes on to note that "notwithstanding passage of the Act, evolving corporate governance practices and pressures from shareholder advocates will ensure an enhanced role for compensation committees in fashioning the next generation of executive compensation policies and programs."

The bottom line is that as a result of regulatory, legislative and other initiatives, boards will face an increased array of compensation-related burdens and responsibilities. These burdens will not only increase the amount of time and effort that boards will be required to spend on compensation issues; they could also expand the board’s potential liability exposures regarding compensation issues.

In a prior post (here), I noted that Executive Compensation may be the "new front line in the litigation wars." The various regulatory and legislative initiatives now emerging seem likely to ensure that compensation issues will define the front line of the litigation wars for years to come.

Will Industry Get Out in Front on This Issue?: Many companies and their executives are well aware of the possibility of regulatory or legislative action regarding compensation issues, and at least some of them are working hard to get out in front of the issue. In that regard, on September 21, 2009, The Conference Board issued a report on the topic of executive compensation, containing proposals echoing the sentiments and even some of the specifics of the regulatory and legislative initiatives. A copy of the report can be found here.

As reflected in the September 21 press release, the recommendations are intended to try "to restore credibility and increase trust in pay practices and oversight." The recommendations include certain "Guiding Principles," including try to "establish a clear link between pay, strategy and performance." The Principles also recommend that public companies should "foster transparency with respect to compensation practices and appropriate dialogue between boards and shareholders."

A September 21, 2009 Bloomberg article about The Conference Board's report and proposals can be found here.

Subprime Update: The Interview: On September 21, 2009, Bruce Carton of the Securities Docket interviewed me in connection with my recent interim update on the subprime and credit crisis class action securities litigation. The interview can be found on Securities Docket, here, and is also embedded below. My prior post with my detailed update about the subprime and credit crisis litigation can be found here.

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