On Friday, Bank of America announced that 4 new directors joined its Board of Directors. For a board of 18 members a turnover of 4 directors may not seem too radical. However, it is the new composition of the board and the reasons why it made the move that are noticeable.

Bank of America is another large publicly-held company that is moving towards an “expertise” board. As we have posted in the past and written about in Acredula articles, an “expertise” board, as we define it, is a board composed of persons each having particular skills or expertise needed for the board to have as a whole, all of the skills and expertise necessary to achieve its future objectives. 

It is being reported that the move was “aimed at satisfying strong suggestions from federal regulators” that Bank of America improve its corporate governance. The 4 new directors would support that position as each has experience in banking or financial oversight-one former Federal Reserve Governor, one former FDIC Chairman, and two former banking executives.

Wall Street Journal article announcing the new board

The Securities and Exchange Commission, according to its officials, will propose new rules today that will pave the way for a company’s shareholders to elect a limited number of independent directors. 

If adopted, the proposal would open the door to a significant change in the role played by investors in governing publicly traded companies.

The proposal would permit large shareholders — typically institutional investors like pension funds or hedge funds — or alliances of shareholders to nominate as many as one-quarter of the directors. For the 700 largest public companies, the proposal would require approval by 1 percent of the shareholders for a dissident slate to be nominated. For smaller companies, it would be either 3 percent or 5 percent, depending on the size of the business.

On Tuesday, Senators Schumer (N.Y.) and Cantwell (Wash.) announced that they had introduced legislation to give shareholders the right to hold advisory votes on executive pay. The legislation also instructs the commission to issue rules that would permit shareholders to propose their own directors.

The N.Y. Times article on the proposed rule can be read here

The Supreme Court agreed on Monday to rule on the constitutionality of the Sarbanes-Oxley Act passed in 2002 to create a new government agency to regulate firms that audit the books of publicly traded companies. The key question in the case is whether the Act violated the separation-of-powers doctrine by the mode of selection and removal of members of the Public Company Accounting Oversight Board. The case is Free Enterprise Fund v. PCAOB (08-861). The case questions the limits on the authority of the president to remove officials in the executive branch. Under it current structure, members of the PCAOB can only be removed for cause by the SEC. 

A copy of the Wall Street Journal Article on the grant of cert can be seen here

The Delaware legislature has enacted a number of amendments to the Delaware General Corporation Law (“DGCL”) relating to the governance of Delaware corporations. These new amendments address current corporate governance issues concerning: 

• proxy access and expense reimbursement; 
• director indemnification and advancement of expenses; 
• judicial removal of directors; and 
• flexibility in setting record dates by providing that the record date for mailing the notice of meeting need not be the same as the record date for determining stockholders entitled to vote. 

The effective date of the amendments is August 1, 2009. 

Of primary importance to the readers of this blog should be the amendment to Section 145(f) of the DGCL and its impact on director indemnification.

Director Indemnification and Advancement of Expenses

The Delaware legislature amended Section 145(f) of the DGCL in response to concerns raised by practitioners and directors following the highly publicized decision in Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. 2008). As you may remember from our earlier Acredula article on the Schoon decision, the court held that, under the indemnification bylaw in question, a former director’s expense advancement rights did not vest until the director was named as a defendant in a suit in which an indemnifiable claim was asserted. In doing so, the Schoon court upheld a bylaw amendment that eliminated a former director’s right to advancement of expenses, despite the fact that the director served under the company’s previous bylaws and left the company’s board prior to the bylaw amendment that eliminated the right of advancement. The bylaw in question did not provide that the director was serving in reliance on the bylaw, that the right to indemnification was a contract right or language that stated any repeal, modification, or amendment to the indemnification or advancement provisions will not adversely affect any right in respect to acts or omissions of any indemnified person occurring prior to such repeal, modification, or amendment.”

With the amendment, the Delaware legislature makes clear that a director’s right to indemnification or advancement of expenses under a company’s bylaws or certificate of incorporation vests at the time of the act or omission that is the subject of the indemnification or advancement of expenses. Further, the amendment provides that such rights may not be eliminated or impaired by amendments to the bylaws or certificate of incorporation after the occurrence of the act or omission for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of the act or omission authorizes the elimination or limitation of indemnification or advancement rights.

While best practices still suggests director and corporations should enter into written indemnification agreements this action by the Delaware legislature does alleviate the concerns raised by the Schoon decision.

Judicial Removal of Directors

The Delaware legislature also amended Section 225, which governs contested election of Directors, to add a new subsection (c), which authorizes the Court of Chancery to remove a director, upon application by the corporation or derivatively in the right of the corporation by any stockholder or member of a nonstock corporation, who has been convicted of a felony or found by a court to have committed a breach of the duty of loyalty in connection with his or her duties to the corporation as a Director. The new section requires a corporation or its stockholders to overcome a substantial evidentiary burden of proving that the director did not act in good faith in performing the acts underlying the conviction or judgment and that the removal of the director is necessary to avoid irreparable harm to the corporation.

COMMENTARY

Governing boards should heed recent actions of the Obama administration apparently calling for a new era of director-centric governance for at least publicly-held companies, financial institutions and, perhaps eventually, tax-exempt entities.

Director-centric governance is in contrast to the strong-CEO paradigm described by Alan Greenspan before New York University’s Stern School of Business on March 26, 2002 and advocated by John and Miriam Carver in their “policy form of governance.” Director-centric governance is the underlying principle of Sarbanes-Oxley: The best defense against mismanagement, fraud and greed is oversight by independent directors with counsel of independent advisers and holding management accountable for providing necessary information.

The Obama administration appears to be taking director-centric governance to the next level: That the best line of “good governance” is governance by independent directors having the expertise necessary to oversee business decisions of management.

Evidence of this new era is Treasury Secretary Timothy Geithner’s March 26, 2009 statement before the Committee on Financial Services of the US House. Geithner states that “[i]nnovation and complexity overwhelmed the checks and balances of the system,” which must include the check and balance to have been provided by the boards of these institutions; “[c]ompensation practices rewarded short-term profits over long-term return,” which indicts these boards’ oversight of the executive compensation of these institutions; and “firms encouraged people to take unwise risks on complicated products . . . [that] outmatched the risk-management capabilities of even the most sophisticated financial institutions,” which second-guesses the these boards’ expertise to oversee the products and their related risks.

Further evidence of the new era includes statements buried beneath the headlines “White House ousts GM chief Rick Wagoner” (March 31, 2009, Los Angeles Times), “U.S. Plays Key Role in Naming GM Board” (April 1, 2009, Washington Post), and “GM Will Replace at Least Six Others on Board” (April 1, 2009, Wall Street Journal). While the media has focused on the removal of Wagoner as CEO, the more substantive change is apparently Wagoner’s removal as Chairperson of the board and the appointment of Kent Kresa, a current GM board member and former CEO of Northrop Grumman Corporation. This had to require approval of GM’s board because the Vice Chairperson who would have otherwise succeeded Mr. Wagoner was Frederick A. Henderson, who instead became CEO.

Despite the conspiracy theories to the contrary, Obama apparently means what he said on March 30, 2009 that his administration has "no intention" of running GM. Instead, the administration wants a better GM board.

According to the Wall Street Journal, at least six, or a majority, of the board is to change. GM’s board has been criticized as a “pedigree” board: Members selected for “who they are” rather than for their experience, skills, and expertise. Most telling is the statement in the Washington Post by new GM Chairman, Kent Kresa, that the GM board needs “new directors with additional skills and experience.”

Boards of organizations that are regulated through federal securities and tax laws, such as publicly-held companies and tax-exempt entities, and boards of major banks, investment banks, insurance companies, and other financial institutions that are likely to become subject to Geithner’s proposed regulatory system, should heed the new direction toward director-centric governance apparently being advocated by the administration:

• The best line of good governance is governance by independent directors having the expertise necessary to oversee business decisions of management; and
• Boards should review their composition in terms of experience, skills, and other expertise, and add new directors where needed experience, skill or other expertise is missing.

The Supreme Court of Delaware announced its much anticipated decision in Lyondell Chemical Company v. Ryan, C.A. 3176 (Del. Mar. 25, 2009) concerning whether the independent directors of a target company’s board were entitled to summary judgment on claims that they failed to act in good faith in conducting the sale of their company. 

The Court of Chancery had denied summary judgment in order to obtain a more complete record before determining whether the directors had acted in bad faith. The Supreme Court reversed that decision and remanded the matter for entry of judgment in favor of the Lyondell directors. In doing so, the Supreme Court held the trial court reviewed the existing record before it under a mistaken view of the applicable law. The Supreme Court indicated that three factors contributed to the trial court’s mistake.

“First, the trial court imposed Revlon duties on the Lyondell directors before they either had decided to sell, or before the sale had become inevitable. Second, the court read Revlon and its progeny as creating a set of requirements that must be satisfied during the sale process. Third, the trial court equated an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of one’s duties that constitute bad faith.” 

It is important to recall from our posting on the trial court’s decision in Lyondell that the offer the board accepted, and forwarded on to shareholders for approval, included:

• A 45% premium over the company’s stock price; 
• 3% break-up fee; 
• A “no-shop” clause (with typical “fiduciary out” language and matching rights for the acquirer); and 
• A fairness opinion 

Yet the trial court was troubled by “the Board’s decision to grant considerable protection to a deal that may not have been adequately vetted under Revlon.”

However, the Supreme Court in its decision confirms that Revlon duties do not arise simply because a company was “in play” and could be potentially acquired. The duty to seek the best available price, under Revlon, applies only when a company “embarks on a transaction – on its own initiative or in response to an unsolicited off – that will result in a change of control.” Additionally, the Supreme Court held that there is only one Revlon duty- to “[get]the best price for the stockholders at a sale of the company.” And, that “[n]o court can tell directors exactly how to accomplish that goal, because they will be facing a unique combination of circumstances, many of which will be outside their control.” 

The foundation of the Supreme Court’s decision was its focus on the effect of the exculpatory provision in Lyondell’s charter precluding director liability for duty of care claims, which allows for only duty of loyalty claims for failure to act in good faith and requires a fiduciary to intentionally fail “to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” The decision is clear that any question about whether directors should have done something differently or more is not sufficient to create post-transaction personal liability. “Directors’ decisions must be reasonable, not perfect. ‘In the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ . . . Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty.”

In overturning the trial court’s decision, the Supreme Court has shown that disinterested, independent directors will not be exposed to personal liability in responding to acquisition offers and affirming the board’s discretion in managing a sales process. 

The Delaware Supreme Court’s decision can be read here.

COMMENTARY

On March 26, 2009, Treasury Secretary, Timothy Geithner, released a statement that our financial system “require[s] comprehensive reform. Not modest repairs at the margin, but new rules of the game.”

Geithner’s statement contains two very telling positions: 

• The first is that “[f]inancial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take.” His premise is that past regulation has not been sufficient.
      
• The second is that “oversight” was insufficient to constrain dangerous levels of risk-taking [by financial institutions] throughout the financial system.” His premise is that the first line of oversight of the these financial institutions, their governing boards, is not sufficient to supervise these risks.

History of past regulation

Historically, major adverse economic events have resulted in legislation by Congress addressing its perception of mismanagement or fraud:

• The stock market crash of 1929 resulted in the Securities Act of 1933 requiring greater disclosure of information by companies before offering their securities in public markets and the Securities Act of 1934 to require continued dissemination of information as long as those securities remained publicly held;
    
• Reporting under-the-table payments to foreign officials as deductible for tax purposes and as legitimate for GAAP purposes resulted in the Foreign Corrupt Practices Act of 1977 requiring the maintenance of books and records and reconciliation of financial statements to those books and records that eventually became known as internal controls;
     
• The failure of illegal acts and third-party transactions to be detected during the audit process resulted in the Private Securities Litigation Reform Act of 1995 requiring audit of public companies to contain audit procedures designed to detect illegal acts, material related party transactions and continuation as a going concern; and
    
• The failure of the audit process to result in adequate disclosure of liabilities incurred by Enron, WorldCom, and others in the late 1990s and early 2000s resulted in the Sarbanes-Oxley Act of 2002 requiring oversight of the financial preparation and audit process of public companies by independent directors.

The focus of these regulations is disclosure with the underlying assumption being that knowledge of the facts will prevent mismanagement and fraud. Opponents of regulation argue that the cost of complying with these disclosure requirements has outweighed any benefit, resulting in public companies going private or changing their domicile to off-shore in order to avoid such costs. Proponents of regulation argue that these regulations have not gone far enough: instead of requiring disclosure, the regulations should regulate the substantive fairness of the operations of business and their transactions.

Mr. Geithner apparently falls within the class of proponents of regulation. His statement proposes regulation of the capital requirements, compensation incentives, and even the size of financial institutions, but also of the products offered by these institutions.

Responsibility for oversight

In the American corporate model, the responsibility for oversight has been traditionally vested in each organization’s governing board. The basic premise of Sarbanes-Oxley is that the best defense against corporate mismanagement is independent oversight of management by independent directors with counsel of independent advisers and holding management accountable for the information provided.

Opponents of regulatory oversight argue that independent directors know more about, and are closer to, the businesses of their organizations, and can take corrective action more quickly and knowledgeably, than any government official or agency. Proponents of regulation argue boards have become a social clubs of the CEO’s best friends and as a result few directors see their interests as separate from those of the CEO and management.

A wish for the future

Although regulation having the breadth of that proposed by Mr. Geithner as with past expansive regulation will directly benefit every lawyer and similar professional, I wish the focus would be on fixing, rather than changing, oversight in the American corporate model.

This focus should be the expertise either present among, or available to, the members of the board not only to provide direction of the organization, but also to oversee risks to the organization’s stakeholders. To me, a better regulatory paradigm is to require disclosure of:

• Whether and, if so, how frequently boards evaluate the collective skills, experience and other expertise of each of their members;
    
• What expertise each board member is believed to contribute to the collective expertise of the board; and
    
• What actions are being taken to enhance the collective expertise of the board through education, recruitment of other members, or access to expert advisers.

Requiring disclosure by each organization of the collective expertise, and steps being taken to enhance that expertise, of those responsible for direction and oversight will empower shareholders and other stakeholders of the organization to protect themselves by making intelligent decisions whether to continue being invested in, employed by, or otherwise relying upon soundness of the organization.

Treasury Secretary Timothy Geithner has proposed sweeping reforms of the financial regulatory system. 

Under the Obama administration’s proposal, the federal government would for the first time have oversight of many complex and previously unregulated financial derivatives, including securities like credit default swaps. 

Geithner also recommended that a single federal agency be granted wide authority to monitor risk across all financial markets.

“To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game,” Geithner said in his opening remarks to the House Financial Services Committee. “The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the structure of our financial system.”

The Treasury Secretary added: “Let me be clear. The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers must end.”

The proposals address four broad themes: containing systemic risk, protecting consumers and investors, eliminating gaps in the regulatory structure and fostering international coordination.

In his testimony Thursday, Geithner stressed the importance of containing systemic risk and said the new proposals offer six methods for addressing the issue:

1. A single independent regulator to watch over systemically important firms and the critical payment and settlement systems used by those firms.
2. Higher standards on capital and risk management for systemically important firms.
3. Registration of all hedge fund advisers with assets under management above a moderate threshold.
4. A comprehensive framework of oversight, protections and disclosure for the over-the-counter derivatives market.
5. New requirements for money market funds to reduce the risk of rapid withdrawals.
6. A stronger resolution authority to protect against the failure of complex institutions.

Another important aspect of the proposal would allow the federal government to seize control of nonbank institutions when they teeter toward collapse, as AIG did last September.

Treasury Secretary Geithner’s entire testimony can be seen here.

Whether warranted or not, commentators and the media continue to place the blame for the financial meltdown at the top of the organizations -- the board of directors. Given the outrage over the AIG bonuses last week, it is no surprise that commentators are again pointing at the board.

“People say that the definition of insanity is doing the same thing over again and expecting a different result. In this case, insanity is allowing the same people to continue to serve on the board after massive failure and expecting them to produce a different result.” 

-Nell Minow

Nell Minow, editor and chairwoman of the Corporate Library, continues to put the boards of directors in the cross-hairs for their actions, or, in her opinion, lack of action that were the failures of strategy and risk management in the troubled companies at the forefront of the financial meltdown. 

In her latest commentary, Nell Minnow addresses why she believes AIG’s board is to blame for the bonuses at AIG and discusses the risks of “overboarding.”

This commentary is available here.

While Washington and the media continue to criticize and analyze the make-up of the boards of those corporations at the heart of the financial crisis and the apparent lack of oversight, the Delaware Chancery Court has taken a step in the other direction. 

In Re Citigroup, Inc., Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009), the plaintiffs brought suit essentially alleging that the directors had breached their fiduciary duties by failing to properly monitor and manage the business risks that Citigroup faced from the sub-prime crisis and by ignoring “red flags” appearing in press reports and news events of the worsening conditions in the sub-prime markets and credit markets.

In its first detailed analysis of potential liability of directors under Delaware law for claims relating to a company’s losses resulting from a substantial exposure to sub-prime debt, the Court dismissed the claims on the grounds of failure to adequately plead demand futility. In doing so, the Court stated, “oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.” And that “[t]o impose liability on directors for ‘making’ business decisions would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second guessing is what the business judgment rule was designed to prevent, and even if a complaint is framed under a . . . [duty of oversight] theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.” 

The decision reaffirmed and clarified several key protections for directors established by the Caremark decision, with respect to oversight responsibilities. 

1. Plaintiff’s face “an extremely high burden” in bringing a claim for personal director liability for a failure to monitor business risk;
     
2. While directors could be liable for a failure of board oversight, “only a sustained systematic failure of the board to exercise oversight- such as an utter failure to attempt to assure a reasonable information and reporting system exists- will establish the lack of good faith that is a necessary condition to liability;” and
     
3. Bad business decisions, absent fraud or illegality, are not evidence of the bad faith necessary to establish oversight liability. But there is an important distinction between oversight liability with respect to business risk and oversight responsibility with respect to illegal conduct.

The Chancery Court has clarified that for directors to be personally liable for a failure in oversight the failure must be more than a failure to correctly predict the future failure or evaluate business risk. “To establish oversight liability a plaintiff must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.” And Catastrophic business losses do not amount to bad faith—at least not according to the Chancery Court in this case.