Governance Issues frequently are the heart of corporate and securities lawsuits. For that reason, the testimony in this type of litigation of corporate governance and management practices experts can be indispensable. In the following guest post, Dr. Stephen Grace, President and Founder of H.S. Grace & Company, Inc., Alvin H. Fenichel, CPA, Senior Advisor at H.S. Grace & Company, Inc., and Joseph P. Monteleone, Esq., the Principal in Catamount Services LLC, take a look at the ways in which the testimony of these experts can be utilized in these kinds of lawsuits, as well as the related question of who is qualified to serve as a governance expert. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
The short and correct answer is No!
Board and management actions are being scrutinized in the numerous securities fraud, breach of fiduciary duty, and ERISA actions that have been filed recently and indeed over the past twenty-five years or more ago. Whether considering the propriety of board and management actions in consummating recent mergers and acquisitions or considering the actions of the board in carrying out its oversight and related responsibilities, corporate governance issues are often at the center of this litigation. This article will address both how the testimony of corporate governance and management practices experts can be utilized in this and other litigation and who is qualified to testify as a corporate governance expert.
Corporate Governance Practices Are At Issue In A Variety Of Causes Of Action
Roles, responsibilities, practices, and processes of both the board and management are at issue in a variety of causes of action.
First, breach of fiduciary duty actions against directors asserting that directors have failed to properly exercise their oversight or decision-making functions or have acted in bad faith or in their own self interest obviously require an understanding of how boards and management function and of the normal and customary business practices and processes of corporate governance which may be applicable. These are typically asserted through a shareholder derivative action against the entire board and possibly also the CEO and other C-suite executives.
Second, securities violations claims in the form of class actions may require an understanding of the roles and responsibilities of directors and individual corporate officers to determine whether fraudulent intent is present or whether a due diligence defense is available to these individuals. And even common law fraud claims involving complex business decisions may implicate corporate governance issues in explaining how and why decisions were made and what structures were in place to ensure good decision-making to address issues of fraudulent intent and misrepresentation.
Third, employee termination and other employment-related cases can take many different forms. Almost all of these cases may involve corporate governance issues and may involve board and senior management action and responsibilities.
Finally, claims involving corporate governance issues may arise in creditors’ claims in a bankruptcy context and claims by certain government agencies.
Distinctions Between Consultative Experts and Testifying Experts
While expert testimony may not take place until the litigation is well underway and all fact discovery has been completed, a party is free to engage a consultative expert at any time and need not necessarily disclose that expert to the opposing parties. Indeed, this is typically done in securities class actions where the defense engages an expert on class damages to provide an assessment of the potential settlement value of the case. Because many of those cases settle after an unsuccessful motion to dismiss, these experts are never disclosed to the plaintiffs. They do, however, assist the defendants in negotiating a settlement by providing a range of reasonable settlement values. Concurrent with examining settlement values, the business specifics of the situation need examination. The examples below reflect the impact of examining these specifics through an experienced business lens.
All too often, parties do not avail themselves of these consultative opportunities.
Ideally, the expert will be engaged through counsel so that all written and verbal communications with counsel will be privileged and not open to discovery by the opposing parties. However, even where defense counsel does not retain the expert, the insurers in the case may do so, albeit more limited in what they can share with the expert without defense counsel cooperation.
Engagement of such an expert should take place as soon as possible, principally to give some guidance as to the viability of the corporate governance claims and defenses that may be at issue. In this way, the parties can get some real sense of the merits of their positions and plan litigation strategy accordingly.
If the consultative expert’s opinions are unfavorable, they need not see the light of day through discovery. If they are favorable, consideration should certainly be given to disclosing that consultant as an expert witness at the appropriate time.
Who Is Qualified to Testify as a Corporate Governance Expert?
Once it is determined that the testimony of a corporate governance expert would be helpful to the trier of fact to understand the evidence, the next question which must be addressed is who is qualified to testify as a corporate governance expert. Courts in the exercise of their gatekeeper role under Fed. R. Evid. 702 or similar state rules of evidence must decide at the outset who is qualified to testify as a corporate governance expert. Under Fed. R. Evid. 702 a witness can be qualified as an expert “by knowledge, skill, experience, training, or education.” Courts reviewing academic credentials have qualified practicing attorneys, law school professors, MBAs, microeconomists, and CPAs as corporate governance experts. But not every attorney, MBA, accountant or economist is qualified to testify as a corporate governance expert. Thus, the need arises to clarify what other qualifications should be expected of those who represent themselves as qualified corporate governance experts.
The Federal Rules of Evidence Advisory Committee in its 2000 notes to Fed. R. Evid. 702) recognized that in some fields experience may be the “predominant, if not sole basis, for a great deal of reliable expert testimony.” Courts must not only look at a proposed expert’s academic or technical training credentials when determining whether that expert is qualified to render an opinion in a given area. Courts must also examine the full range of the expert’s practical experience to answer this question. See, e.g., U.S. v. Parra, 402 F.3d 752,758 (7th Cir. 2005)
There are many situations in which experience may trump academics. For example, a Ph.D. in food science qualified by education may be able to explain what pathogens contaminate food, but if the question at issue is customary safety practices and processes used in a kitchen to avoid food contamination, a chef with years of experience in preparing food is more qualified than the food scientist to answer this question. Similarly, a mechanical engineer may be able to explain the forces at play on a racehorse’s legs in running a race, but if the issue is what to do to avoid injury in running a race, a jockey qualified by years of practical experience in riding horses in races, can more credibly answer the question than the mechanical engineer.
Similarly, those with practical experience in corporate governance are generally better able to explain good corporate governance practices than those simply qualified by academics. Courts, for example, have focused on experience in both corporate law and securities law, in qualifying attorneys as corporate governance experts. Lawyers testifying on corporate governance issues, however, may have their testimony excluded, or at least limited, based on the well-recognized principle that experts cannot testify about legal issues. In court, there is only one legal expert – the judge. See, e.g. Askanase v. Fatjo, 130 F.3rd 657, 673 (5th Cir. 1997). Oftentimes, lawyers as expert witnesses are challenged based upon the allegation that they are rendering impermissible opinions on the law.
In the management area those with actual, real-world C-suite management or board experience are qualified to testify on corporate governance practice issues. Those who have sat on or advised boards and been involved in making key decisions understand the process and the structures necessary to govern an organization effectively and fairly. General knowledge of the primary activity areas within companies, i..e. production, marketing, finance and accounting, legal, research and development, human resources, external relations, and IT is required, as well as an understanding of both formal and informal organizational structure.
Experience with external financial reporting processes and other corporate communications, including annual filings, interim filings, proxy statements other SEC filings and SOX requirements is frequently important. Knowledge of how oversight and control systems and checks and balances, both formal and informal, actually work within an organization is key. Such systems go well beyond review of the income statement and balance sheet and must focus on operating cash flows, capital expenditures and other key value drivers. Familiarity with the functioning and structure of board committees such as the audit committee, the compensation committee, the nominating/governance committee, and the evolving risk management committee can also be useful. (See H. Stephen Grace, Jr. and John E. Haupert, “Corporate Governance Consultants: The Issue of Qualifications” May 2007 NACD – Directors’ Monthly. (See the H. S. Grace & Company website http://www.hsgraceco.com for earlier articles by John Haupert, Sheryl Hopkins and Stephen Grace addressing issues discussed in this article.) The ability to explain the uncertainties involved in making business decisions and the processes, practices, and information necessary to make good decisions may best reside in those who have made these decisions.
Corporate Governance Testimony Is Specialized Knowledge Which Can Be Helpful to Courts and Juries Under Applicable Rules of Evidence
In the context of these actions courts and juries are increasingly asked to assess and evaluate complicated business decision-making and oversight decisions. Good business decisions sometimes have bad outcomes. To avoid having these cases tried by hindsight, it is important in these types of cases that the trier of fact understand both the context in which business decisions are made and good corporate governance and management practices and processes for making decisions. Business mores and governance practices evolve over time. What steps should be taken, procedures followed, and information considered in making these and similar decisions and what individual officer and director roles and responsibilities should be in the process are complicated issues important to the fact finder. But executive compensation issues, provisions in mergers and acquisition agreements, financial decision-making issues, director oversight responsibilities, and disclosures in financial statements or SEC filings, to name a few, are not exactly everyday stuff within the common experience of most courts and jurors. Testimony explaining both the context in which the board or management acted and customary business practices, standards of conduct and procedures for boards or management can, therefore, be helpful to the court or the jury in deciding the case.
Fed. R. Evid. 702 recognizes that expert testimony is admissible where “specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact at issue.” This is the rule applicable in the federal courts, but most states have similar rules of evidence. Courts have for some time recognized that complex corporate management process and practice issues are beyond common experience and may require expert clarification. See, e.g. Bauman v. Centex Corp., 611 F.2d 1115, 1120-1121 (5th Cir. 1980) (corporate management issues may be complex and require expert testimony; the court admitted expert testimony of management consultant on corporate finance issues)
The following three real life examples demonstrate how attorneys can use corporate governance and management practices experts in breach of fiduciary duty, securities violations, fraud, bad faith claims and other cases.
1. Breach of Fiduciary Duty Claim against Independent Directors
In breach of fiduciary duty actions against directors and officers, the court or the jury must determine whether directors and officers acted in an informed manner with the best interests of the corporation in mind and in good faith. To help make these determinations, expert testimony is useful to explain both the context in which the directors or officers acted and customary business practices, standards of conduct and processes considering the specific circumstances. The following breach of fiduciary duty action against the independent directors of a bankrupt corporation illustrates how corporate governance and management practice testimony can be used in these types of cases.
In this case the liquidating trustee of a creditor trust established in connection with a Chapter 11 plan of reorganization sued the independent directors of a twice bankrupt energy company asserting: 1) the independent directors elected after the corporation first emerged from Chapter 11 had breached their fiduciary duties by pursuing business strategies that were excessively risky and not in the corporation’s best interests; and 2) the directors knew these risky strategies represented a material conflict of interest between the CEO and the corporation, since these strategies offered the CEO the only opportunity to regain control of the corporation. Specifically, plaintiff alleged that the independent directors had abdicated their corporate governance responsibilities, approved the expenditure of large sums of money in high risk oil and gas exploration ventures, and engaged in self-dealing.
The corporate governance expert reviewed the allegations and addressed each allegation to determine if customary business practices and processes were followed. The expert found that the independent directors had acted appropriately because:
- The independent directors were well-informed and appropriately interacted with and relied on management and exercised experienced and reasonable judgment in addressing their responsibilities in an effort to make the reorganized entity a success.
- The oil and gas industry is inherently a risky business and risk sharing is a business judgment.
- The directors were independent and were not excessively compensated; there was no self dealing.
- Certain senior creditors in the first bankruptcy proceeding, operating as a bondholder committee, negotiated the CEO’s employment agreement and incentives and were directly involved in the selection of the independent directors. The company’s strategy was developed and put in place by the bondholders as part of the Plan of Reorganization and was approved by the court. The strategy was based on the bondholders’ experience with the CEO and on their belief that he was a talented natural resources finder.
- The CEO would never have regained control of the corporation under the employment agreement negotiated by the bondholder committee, even if the plan had been successful. The senior noteholders, regardless of the success of the reorganized firm, would have retained control. In fact, the employment contract anticipated the bondholders replacing the CEO if the plan was successful.
- The damages claimed by plaintiff in the form of loss of value were speculative and not based on any evidence; the claimed damages were not causally related to any actions of the independent directors.
This analysis helped explain the context in which the independent directors had acted to show that they had acted in an informed manner with the best interests of the corporation in mind and in good faith. The case was ultimately dismissed on defendant’s motion for summary judgment.
2. Bad Faith Claims
Corporate governance and management practices experts may also offer helpful testimony in other types of complex commercial litigation. The following embezzlement case, in which plaintiff claimed damages of almost $19,000,000 against defendant bank, again shows how testimony on corporate governance and management practices can be utilized effectively in such cases.
Two of plaintiff’s employees embezzled almost $1,000,000 over several years from their employer by setting up a fictitious bank account at defendant bank. The embezzlement resulted in the plaintiff company’s insolvency. The company sued the bank asserting that the bank was negligent, acted in bad faith, and failed to follow reasonable commercial standards of fair dealing by accepting checks and wire transfers into the fictitious account without proper endorsement. After reviewing the evidence in the case, the corporate governance expert, testifying on both liability and damage issues, destroyed plaintiff’s claims, as follows:
- The two employees had commenced their embezzlement scheme several years before the fictitious account at defendant bank was opened, a fact unknown to plaintiff at the time it filed the initial petition. In fact, the employees had employed fictitious accounts at three other banks prior to opening the account at defendant bank and embezzled a total of almost $2,000,000 through the fictitious accounts at multiple banks.
- The embezzlement resulted from both a lack of and a failure of internal controls at plaintiff and from a highly unusual and inappropriate delegation of responsibilities by the company’s owner.
- Significant problems with the timely and accurate production of financial statements by plaintiff also contributed to the lax environment, which allowed the two employees to undertake and continue the embezzlement scheme for several years.
- Plaintiff company’s damage claims were not supported by the evidence.
After an extensive trial, the jury found that plaintiff had direct damages of only $120,000. The jury further found that plaintiff itself was responsible for 95% of this $120,000 in damages and that defendant bank, was responsible for only 5% of the damages or $6,000. The jury also found there were no consequential damages.
3. Securities Violations Claims
Claims for violations of the Securities Act of 1933 and the Securities and Exchange Act of 1934 against companies, directors and officers frequently require an understanding of the roles and responsibilities of directors and individual corporate officers to determine whether fraudulent intent is present or whether a due diligence defense is available. The following Rule 10b-5 (promulgated under the Securities and Exchange Act of 1934) claim by the SEC against a CEO demonstrates the types of issues where corporate governance testimony may assist the fact finder.
The SEC sued defendant CEO of a software company claiming that the CEO had intentionally orchestrated the misstatement of the company’s financial statements through an accounting fraud, which ultimately resulted in a restatement. The SEC further asserted that the CEO’s certification of the restated financial statements was an admission of wrongdoing. While at first glance, this case might appear to have called exclusively for accounting expert testimony, the real issue in the case was not whether the accounting was right or wrong, but whether the non-accountant CEO had exercised appropriate judgment in addressing the accounting issues and in relying on accounting professionals.
Defendant’s corporate governance expert evaluated the allegations and explained how companies are organized and what the CEO’s role and duties were in this situation as follows:
- All companies must rely on a division of labor to operate.
- By necessity the CEO must rely on the expertise of others within the company to fulfill his duties and obligations in his role in the overall management of the company.
- The proper accounting for transactions under GAAP is not always a black and white issue and requires accounting expertise.
- The CEO was not an expert in accounting and had the right, in this instance which involved complicated accounting issues not fully resolved by the accounting rules, to rely on the accounting judgment of both internal and external accounting professionals as to the proper way to account for the transactions in question.
- The CEO had not ignored his duties, but rather had diligently performed those duties by seeking the advice of experts in an effort to fulfill his obligations.
This analysis was helpful to show that the CEO had acted appropriately without fraudulent intent. The case was settled for a nominal five figure sum after the judge stated at a pre-trial hearing that he did not believe a fraud charge could be supported at trial.
In summary, it is important to give early and strong consideration to the engagement of a corporate governance expert. Such an expert can be engaged in the earliest stages of litigation and even before litigation is commenced.
It is also critical to engage the right expert. The ideal expert will be well-qualified with C-suite level executive experience and/or board experience. The expert should have history where he or she was previously qualified at trial as an expert and has withstood prior challenges to any reports or deposition testimony.
The monetary cost of early proactivity is minimal – usually contained within five figures – when compared with the tens of millions of dollars of litigation costs that typically attend the litigation. Thus, these are dollars very well spent.
ABOUT THE AUTHORS
H. Stephen Grace, Jr., Ph.D
Dr. Stephen Grace is President and Founder of H.S. Grace & Company, Inc., a litigation support, expert testimony and business consulting firm serving corporate officers and directors and their counsel as well as other organizations and individuals. The firm has offices in Houston and New York and has provided services both nationally and internationally. Dr. Grace is an economist, consultant and longtime expert witness on corporate governance, business practices, and damages arising in business disputes. His prior business career included senior responsibilities in organizations involved in real estate, oil & gas, national sports team franchises, auto and equipment leasing, and other areas. In these roles, he managed financing and guided entities through bankruptcy and troubled debt situations. Since founding H.S. Grace, he has assisted in litigation involving complex commercial disputes in the energy, banking, financial and insurance industries and in numerous other organizations including partnerships and non-profit entities. He has also assisted clients in defending against shareowner derivative suits and regulatory enforcement actions. H.S. Grace & Company’s resources include thirty-plus advisors and expert engagement staff members from a wide range of industries and professional disciplines. For additional information about the firm and its work, see www.hsgraceco.com.
Alvin H. Fenichel
Al Fenichel has extensive financial management and senior executive experience spanning both domestic and international environments in insurance, financial services, recorded music, and consumer product businesses. His expertise includes acquisitions and divestitures, domestic and international management and financial reporting, corporate controls and compliance, and change management. Most recently, Al served as the Senior Vice President and Chief Accounting Officer of AXA Financial and AXA Equitable Life Insurance Company, both SEC Registrants, retiring in 2012. Previously, Al served with CBS Inc. as the Finance Officer of its Consumer Products Group and as the officer responsible for Global Internal Audit. He is a past president and member of the Board of Directors of the New York City Chapter of Financial Executives International, a member of the Town of Greenburgh, NY Water Advisory Committee and the Rider University Accounting Advisory Council. Al also serves as the coordinator of the HSG’s New York Litigation Support and Consulting Team.
Al represented CBS Inc. in front of the SEC Enforcement Division in Washington related to an industry-wide investigation of field broadcast operations, and later was deposed by the plaintiff in connection with civil litigation brought against CBS Inc. related to the sale of property. In his work at AXA, Al worked extensively with in-house and outside counsel in connection with acquisitions, dispositions, and commercial contracts. At HSG, Al has performed expert examinations of documents supplied in discovery and developed analyses of facts and factors supporting or refuting allegations. He also has served as a speaker in HSG’s business and professional programs for law and insurance clients.
Joseph P. Monteleone, Esq.
Mr. Monteleone is the Principal in Catamount Services LLC. Prior to forming Catamount in 2023, he was a practicing lawyer with extensive experience managing D&O and other professional liability claims and litigation, drafting insurance policy language, and developing new claims procedures and insurance products.
He provides expert testimony to insurers, policyholders, and brokers, specializing in claims handling practices and industry customs. He is a certified arbitrator (ARIAS-US) and mediator (International Institute for Conflict Prevention & Resolution (CPR). He provides services such as reinsurance audits, policy drafting and consulting. For more information on Joe, please visit his website at www.catamountservbicesllc.com and his LinkedIn profile at https://www.linkedin.com/in/jpmonteleone/