National Association of Corporate Directors’ Report on "Director Liabilities: Myths, Realities, and Prevention"

By the Corporate Governance Group

On December 7, 2005, a blue ribbon commission of the National Association of Corporate Directors issued a report¹ containing several recommendations for addressing the "new liability landscape." Among these recommendations are that directors should:

• Ensure that they are free from conflict and that their independence is uncompromised. They should assume and carry out their duties meaningfully and responsibly. They should assure that their fellow directors are well-qualified persons of integrity; that the board has the skill sets it needs to oversee management’s performance effectively; and that senior management is comprised of persons of integrity who set the right ethical tone overall and specifically for improving corporate governance.

• Be diligent and attentive to all board matters, avoid self-dealing and be strict in observing and adhering to procedures for addressing conflicts of interest.

• Understand the business, financial and competitive environments, the systems of controls and compliance, the culture, financial statements and the business strategies and risks faced by the companies that they serve, in addition to understanding their own general and specific legal obligations and fiduciary duties as directors.

• Pay special attention to the board agenda and the flow of information to the board; attend meetings well-prepared to engage actively in board deliberations, with an attitude of healthy skepticism and constructive criticism when necessary; insist on timely receipt of and read drafts of financial reports and public filings and ask questions about anything that is not clear or that causes concern; and insist that management circle back to issues decided or discussed for updates and progress reports.

• Insist on regular executive sessions without management to consider the quality of the management team and to discuss other important issues about which the board is being asked to act.

• Understand every item, transaction, or public filing put before the board for approval and ask management and auditors for appropriate assurances and representations regarding the integrity of reporting and the processes relied upon.

• In reviewing registration statements, prospectuses and the public filings that they incorporate, and discuss within the board and with management, the auditor and with counsel whether there are any additional steps that directors should take to assure themselves of the accuracy of documents filed with the SEC, whether there are any unusual aspects, close calls or other problems with particular disclosures and whether there are potential red flags that may not be apparent to non-experts.

• As to any issue or transaction that involves a potential conflict for a member of management, a director or a controlling stockholder.

Despite an increase in litigation and investigations targeted at boards and their individual directors, and headlines about staggering settlements, the authors dispute the common perception of changing or new standards or an increased likelihood of liability. Instead, the commission sees recent cases as applying, upholding and clarifying long-standing standards of liability in the face of sometimes egregious facts.

Although the report believes that the standards of review against which directors are measured for purposes of legal liability have not changed, in a world of increasing scrutiny and potential for enforcement actions and litigation, directors should aspire to the highest standards of conduct and best practices enabling them to "focus on the strategic issues that can build long-term stockholder value, [thus] fulfilling the essence of their duties as fiduciaries."

The report reviews recent state and federal law developments in order to help directors "sharpen their understanding of their fiduciary duties, the requirements imposed by securities laws, and where the risks to their own personal assets lie."

Using Delaware as the model, the authors outline applicable state law standards for review of director conduct. Generally, state law binds directors as fiduciaries "to act with loyalty to the corporation, to exercise care in the performance of their responsibilities and to carry out those responsibilities in good faith." Loyalty requires action in the best interests of the company free from conflicts of interest. Due care requires that directors’ business decisions be adequately informed and the result of appropriate due diligence. Good faith requires that directors responsibly carry out their duties with honesty of purpose and in the best interest of the corporation. State courts will apply the business judgment rule in assessing whether directors have violated these fiduciary duties. State courts will focus not on the result of the directors’ business decision but on the process by which the decision was made so as to encourage "entrepreneurial risks by protecting [directors] from liability for good faith, non-conflicted, informed, rational business decisions." The report also discusses certain state law and other protections or protective devices available to directors in defending themselves in and against litigation, including non-conflicted director independence as a defense in and against derivative lawsuits, the use of state exculpation and indemnification statutes, good faith (but not blind) reliance on experts and insurance.

According to the authors, recent cases, such as the Emerging Communications case in 2004² and the 2005 Disney case,³ demonstrate that:

1. The business judgment rule has not been undermined;
2. A director’s "level of good faith in applying his expertise" is the proper basis for liability and not the director’s mere status as an expert;
3. Each director will be judged on the basis of whether his or her conduct was undertaken in good faith, (i.e., "without an intentional disregard of known responsibilities"); and
4. Striving to meet evolving, aspirational, best practice standards of conduct does not expose directors to a higher standard of review as to their business judgments.

The report recommends that directors adopt the "aspirational" (or highly ambitious) best practice standards of conduct that can help them avoid claims that they have not met their fiduciary duties.

Under federal law, the report emphasizes that:

1. A director’s obligations generally are related to "prompt, full, fair and accurate disclosure of all material information that will affect a corporation’s securities;" and
2. The director’s "greatest liability exposure arises in the context of issuing stock or debt."

The report primarily focuses on the director’s obligations under Section 11 of the Securities Act of 1933.⁴ Defending against these claims is difficult and extremely fact-sensitive, requiring directors to prove that they acted with "due diligence," meaning, in practical terms, that a director must have been actively involved in ensuring that the registration statements and the other reports and filings (e.g., Forms 10-K, 10-Q and 8-K) that are incorporated therein do not contain material misstatements or omissions. This requires best practice approaches, such as "substantial probing of management, bankers and experts" (even when awkward), particularly with respect to red flags about which directors must "inquire until satisfied as to the integrity" of the information. It also requires "receiving reports; requesting information from management; meeting periodically; and analyzing, planning and participating in the corporation’s business."

The authors also believe that going beyond compliance reduces litigation and liability risks and allows for greater focus on the real business of the corporation, which is the proper province of an empowered board. Going beyond compliance requires:

First, that the board understand its own authority and determine "which issues merit [board] action" from among the wide range of matters on which the board may be required or called upon to act. The board should devise and adopt "levels of authority" guidelines, which prescribe the matters that must come before the board for action or merely for review and/or discussion.

Second, that the board assure that it has access to a reliable system of formal and informal, real-time information flow. Such a system provides directors with important management, non-management and expert information upon which the directors can rely. The information must be geared to the nature and complexity of the company’s business and its strategies, as well as to the particular issues or matters confronting the company at any given time. The primary source of such information will be management, but boards and their directors must not be constrained to such sources. Instead, directors "should seek and obtain additional information from any source they deem appropriate, while taking care to ensure that they have sufficient basis to rely on that information." These sources include senior and non-senior management, as well as non-management employees, fellow directors, third parties such as experts and academics, on-site visits, employee hotlines and stockholder and customer/creditor surveys. All such information should be subject to active discussion, which includes asking tough and critical questions.

Finally, that the board’s composition be comprised of directors who have an independent perspective characterized by the courage and integrity "to ask searching questions and to follow through until they have a proper understanding of the matter at hand." The board should also have a diversity of experience and expertise (including industry, functional and product/service expertise) and should engage in periodic self-assessment and evaluation.

Structurally, the report underscores the great importance of conducting executive sessions of non-management directors and the increasing importance of board committees in carrying out the workload of the board, including the value of committee work being regularly shared with the entire board. The report stresses the need for a lead director to preside at executive sessions and to communicate with the CEO afterwards. Among other things, executive sessions should also be opportunities for the non-management directors to meet with individual executives (such as the CEO, the CFO or the chief legal officer) and others in order to "probe more deeply into certain issues" affecting or likely to affect the company.

The report also examines three important areas that have been the subject of recent increased scrutiny: executive compensation⁵, mergers and acquisitions, and capital formation.

The report emphasizes that executive compensation decisions require appropriate measurements of executive and company performance and effective assessment against those metrics. Directors making compensation decisions require a full and complete understanding of the financial implications of such decisions under all scenarios reasonably likely to unfold.

In the merger and acquisition area, a reliable and continuous systematic flow of information to directors is critical at all times and not just in specific transactions, because the board should be prepared for opportunities and threats even when there is no pending or foreseen transaction. In this vein, directors should periodically receive information regarding comparative analyses of various strategic options, possible acquisition targets, and the merger activity of competitors. Of course, particular transactions require specific detailed information about price, timing, certainty, proposed financing and impact, as well as the possibility of independent outside expert assessments, all of which must be evaluated critically and independently by the directors.

Capital formation, credit transactions and securities offerings also require a reliable system of information flow so that directors are familiar with the company’s financial situation through an ongoing understanding of the company’s business, its financial needs, sources of funds, financial controls and financial disclosures.

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