Liability and Your Board of Directors

Decisions made by public companies' boards of directors face greater scrutinyand increased possibility of being challenged in a courtroom

As the economy continues to falter due to the ongoing recession, officers and directors of public companies face the increasing possibility that their decisions will be challenged by investors, regulators, and even criminal prosecutors. This increased scrutiny makes it more important than ever that directors understand their obligations and potential liabilities.

Public criticism of executive compensation packages has grown as the recession has continued. On a near-daily basis, headlines highlight stories of bigname companies assailed on all sides by resentful shareholders and their legal representatives. In addition to private litigation, the government is increasing its activity on this front. The recent publicity and threatened government action concerning the AIG bonuses is just one example of this increased scrutiny. Another aspect is the recent announcement by Chairman Mary Schapiro that the Securities and Exchange Commission (SEC) is preparing a measure that will press corporate boards to explain in more detail how the board oversees risk. With these new initiatives come new potential litigation hazards for directors.

Compensation: The Doctrine of Corporate Waste

While the scope of the potential liability on compensation issues is not fully clear, a recent Delaware decision establishes that in certain instances, directors can be liable for excessive compensation decisions under a theory that by making the payments, they are wasting corporate assets.

In a case involving Citigroup, the Delaware Chancery Court dealt with allegations that the directors of Citigroup had violated their fiduciary duties to the corporation by approving a multimillion-dollar payment and benefit package upon the retirement of Citigroup's CEO. The plaintiffs alleged that this payment constituted a waste of corporate assets because the value of the compensation package far outweighed the value of any future benefits that the former CEO would provide to Citigroup.

In declining to dismiss this claim at the pleading stage, the Court held that while the directors of a corporation have broad discretion and authority with respect to executive compensation decisions, that authority is not unlimited. The board's discretion is bound by an outer limit "at which point a decision of the directors on executive compensation is so disproportionately large as to be unconscionable and constitute corporate waste," wrote Chancellor William B. Chandler in the decision. Without reaching the ultimate issue of whether the compensation in this case was excessive, the Court held that the allegations that the former CEO had received $68 million and other valuable consideration in exchange for a non-compete agreement, a non-disparagement agreement, a non-solicitation agreement, and a release of claims at least raised a reasonable doubt about whether the severance package was so onesided that it was beyond the "outer limit" described by the Delaware Supreme Court. In reaching this decision, the Court noted that on the face of the pleadings the record was unclear as to the real value, if any, of the promises given by the former CEO in the non-compete and related documents. On this basis, the Court allowed this portion of the plaintiffs' claim to go forward.

The importance of the Citigroup decision to directors is clear: plaintiffs and the courts are willing to look beyond executive compensation decisions in order to evaluate whether the corporation is getting a benefit from the compensation, or whether the compensation approved by the board is "so disproportionately large as to be unconscionable and constitute corporate waste." It remains to be seen what position the SEC will take in its compensation measure. In the interim, directors should bear the Citigroup ruling in mind when making compensation decisions.

Risk-Oversight Liability

Legal scrutiny of executive compensation decisions is not the only outgrowth of the current economic crisis. The subprime lending crisis, along with other current issues, has led to claims against directors alleging that they have breached their fiduciary duties by failing to adequately oversee and manage corporate business risk. In essence, these claims seek to impose liability on directors for bad business decisions under the guise of inadequate oversight.

In the same case involving Citigroup, the Delaware Chancery Court dealt with the issue of the Citigroup directors' alleged responsibility for inadequate oversight of the corporation's business activities. In dealing with the directors' liability in that case, the court issued a ruling favorable to corporate directors faced with similar oversight allegations.

The allegations against the directors in Citigroup were that they had failed to properly monitor and manage the risks that Citigroup faced as a result of problems in the subprime lending market. The plaintiffs contended that under the Chancery Court's prior decision in Caremark, the directors could potentially be liable for failure to conduct appropriate oversight in circumstances in which due attention would have arguably prevented a loss.

In rejecting the failure of oversight claims, the Court distinguished the situation in Caremark from the allegations in Citigroup. In Caremark, the Court had dealt with the issue of whether the directors had failed to exercise their oversight function in a case where employees were involved in criminal activities. In analyzing their potential liability, the Court held that a "sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—would be sufficient to establish a lack of good faith by the board and potentially subject the board to liability for failing to act in a situation where due diligence would have prevented the loss."

In holding that the Caremark standard did not apply to the business oversight claims in the Citigroup case, the Court emphasized that under a failure-to-exercise-oversight theory, bad faith was a necessary condition to director liability. As a result, such claims require a showing that the directors knew that they were not discharging their fiduciary obligations or demonstrated a conscious disregard for their responsibilities. While that situation had potentially existed in Caremark because of the nature of the allegations, the court held that with respect to business risk oversight, directors are entitled to the protections of the "business judgment rule." That rule creates a presumption that in making a business decision, the directors acted on an informed basis, in good faith. The Court held that under the business judgment rule, a court will not second-guess a corporate board absent gross negligence bad business decisions are not enough. Accordingly, the Court held that the plaintiffs face an extremely high burden in attempting to state claims against corporate directors for failure to oversee business risk and that they had failed to state such claims against the Citigroup directors.

Advancement of Legal Fees

If claims are brought against directors, the most significant issue that they face on a personal level is whether they are vulnerable to possible "out of pocket" liability for the claims. While insurance covers most claims, there are instances when directors and corporate officers need to rely on the corporation to pay their legal fees and to indemnify them from damages that result from such claims.

Virtually every state authorizes corporations to indemnify their officers and directors after the fact for expenses incurred in connection with defending themselves in legal proceedings arising out of service to the corporation. Most corporations enact bylaws specifying that officers and directors are entitled to be indemnified for expenses (including attorneys' fees) incurred in connection with defending themselves in legal proceedings, as well as for any judgments, fines and amounts paid in settlement. The underlying public policy for this type of indemnification is that absent fraud or breach of fiduciary duty, people who serve as corporate directors and officers should be able to perform their jobs free of the fear that they will be saddled with personal liability for corporate acts.

Notwithstanding a corporation's broad powers to indemnify its officers and directors, such provisions have little practical significance until after the legal proceedings have concluded. Whether an officer or director is entitled to reimbursement for legal expenses incurred during the course of the legal proceedings is generally determined after the proceedings are over.

Because of the harsh reality of funding a legal defense, Delaware and other jurisdictions provide that a corporation may advance litigation expenses to officers and directors prior to the "final disposition" of the proceeding. While most states provide corporations with the option to advance litigation expenses, many corporations, in their bylaws, provide that they must advance litigation expenses to their officers and directors. In addition, many officers and directors have separate employment agreements or indemnity agreements that require mandatory advancement.

A recent Delaware decision has raised an issue with respect to the right to advancement. More particularly, it deals with the issue of whether a corporation can reduce its advancement obligations to an officer or director after the individual is no longer associated with the corporation. This is obviously a potentially significant issue when a new board takes over a corporation or when a corporation potentially becomes subject to government control as a result of the receipt of Troubled Asset Relief Program (TARP) or other federal funds.

In Schoon v. Troy Corp., the Delaware Chancery Court dealt with the issue of whether a corporation could eliminate a director's advancement rights after the director left the board. In that case, a former Troy director sought advancement of the legal fees that he was expending in connection with a breach-of-fiduciaryduty claim brought against him by the company. The director contended that during the time he was a director, the company's bylaws had required the advancement of fees and that as a result, his right to advancement had vested during that period. In response, the company contended that it was not required to advance fees because after the director had left the board, the company had changed its bylaws so that advancement to former directors was no longer required.

In rejecting the former director's request for advancement, the court held that the right to advancement of fees had not vested while he was on the board and that the subsequent bylaw change was effective in depriving the former director of this right. In reaching this conclusion, the Court emphasized that there was no evidence that the bylaws had been changed in anticipation of the director's actions—rather, the change had been made in the normal course of business.

The significance of the Schoon decision to officers and directors is obvious. While it may be rare for corporations to reduce existing advancement obligations through bylaw amendments, the possibility of such an amendment does exist. Thus, directors who have left a board with the belief that they will receive advancement if they are dragged into litigation could discover years later when claims are filed that the corporation has changed its bylaws and advancement is no longer required. The economic consequences of such a change could be devastating.

Under the TARP

Finally, there is one issue that exists for directors of financial institutions as a result of the financial crisis that may also have an impact on non-financial entities. That issue is the future regulatory impact on all corporations that have participated in TARP, and the creation of a new government regulator, the Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) to assist in monitoring the use of TARP funds.

While it is too early to say what the full litigation impact of the TARP program will be on financial and non-financial institutions, one thing is clear: Firms will need to closely examine their dealing with TARP funds and their accountability for the use of those funds. While the SIGTARP is directly responsible for auditing and investigating the use of TARP funds by financial institutions, the authority of that office does not stop there. With a $15-million budget, SIGTARP has publicly announced it has the right to investigate and audit "any TARP dollar, anywhere it goes." This presumably includes nonfinancial institutions that deal with or receive funds from the original recipients of the TARP.

Further, both the Emergency Economic Stabilization Act of 2008 (EESA), the legislation under which TARP was created and implemented, and the American Recovery and Reinvestment Act of 2009, signed into law by President Obama on February 17, contain provisions relating to executive compensation and the oversight role of boards of directors in this area. For example, boards and compensation committees must adopt company policies with respect to approval of excessive or luxury expenditures as identified by Treasury and must evaluate employee compensation plans in the light of any risks posed to the TARP recipient from such plans. The acts also impose other obligations on boards that have traditionally been reserved for companies' management teams.

In February, SIGTARP began sending detailed "letters of inquiry" to companies that were recipients of TARP funds, including financial institutions and major U.S. automakers. The letters requested detailed information regarding the companies' anticipated use of TARP funds, actual use of TARP funds, and whether these funds were segregated from other institutional funds. Of particular note, the letters included a request that the companies provide information on "specific plans and the status of implementation of those plans, for addressing executive compensation requirements associated with the funding." In addition to requesting information related to the expenditure and compensation issues, the letters asked for details on how executive compensation limitations will be implemented in line with Department of Treasury guidelines and whether any such limitations "may be offset by other changes to other, longer-term or deferred forms of executive compensation."

The responses to these letters are to be signed by a duly authorized senior executive officer of the company who certifies the accuracy of all statements, representations, and supporting information provided. In subsequent guidance, SIGTARP clearly indicates that it is not seeking certification of compliance with TARP. However, the letters do not clearly exclude boards of directors for accountability for the contents of these responses or the programs and policies described therein, leaving open the possibility of further investigations into director oversight.

As TARP and its related programs move forward, directors on both financial and non-financial corporate boards will need to educate themselves on the issues that these federal programs will create for their entities and should be prepared for the possibility that actions with these funds will be subject to SIGTARP review. Directors may also consider the creation of a corporate oversight board tasked with monitoring issues that may arise in relation to TARP and the use of TARP funds. James Sanders, a former federal prosecutor and regional administrator with the Securities and Exchange Commission, is a partner at law firm McDermott Will & Emery.

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