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.

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.

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.

Today, nonprofit corporations are saddled with a changing governance environment that brings with it a need to examine current board practices and consider new ones. These changes in expectations for nonprofit boards have been prompted, in part, by the new Form 990 but also by the economic crisis fueled by the host of for-profit meltdowns of AIG, Lehman Brothers, Freddie Mac, Fannie Mae and others this past year. 

While the economic crisis was not driven by nonprofit companies, it will impact corporate governance of all organizations. This crisis has generated discussion and rumored regulation, and it requires nonprofit boards to adopt new practices. The evolving changes in today's governance best practices - and the way nonprofits should respond - are critical to the health and sustainability of the organization. 

Wall Street has shattered the public trust and confidence in the for-profit world, and retaining the public trust and confidence in charitable organizations and nonprofits is critical to accomplishing their missions. However, without shareholders, nonprofits are missing the built-in accountability of the for-profit world, which means that the boards and executive directors of nonprofits must play the role of watchdog to ensure that the public trust and confidence is maintained and to do their part to resurrect corporate America without increased regulation. 

To do so, it is incumbent on all boards to take a step back, take a critical look and assess their structure, composition, committee charters and past performance and determine whether they are prepared for the current challenges and risks to the organizations. 

As we embark on what will certainly be an uncertain year, nonprofit boards should consider taking the following steps to maintain the public's trust and confidence in their organizations and to act before the government can react: 

• Board Education. Boards should begin with educating their members to be better directors, to become more familiar with the risks to their organizations, to be more aware of the strengths and weaknesses of the members of management and to learn how to hold management accountable for information being provided.

• Assess Current Board Experience and Add Directors with Needed Experience, Skills and Expertise. Boards should assess and create a database inventorying the experience, skills and expertise of their current members. That database expertise should be reviewed periodically to evaluate whether the correct mix is represented by the current members of the board. The goal of the organization should be to create an "expertised board" composed of persons each having particular experience, skills or expertise needed for the board to have as a whole.

• Access to Independent Advisors Who Can Provide Necessary Counsel. Because it takes time to constitute a board composed of the appropriate mix of experience, skills and expertise, a board should require that it be given access to independent advisors having the experience, skills and expertise to counsel the board. This requires a board to first have access to a database of such advisors and then to have the resources to retain those advisors to counsel the board. This is important because it is likely that boards will be judged by state attorney generals, regulators, donors and eventually courts by the least experienced, least skilled or least knowledgeable of its members unless such members have access to such counsel. 

• Coaching on Asking Questions. Boards should periodically receive coaching or training on how to ask questions, including: the purposes for which they should be asking questions; the extent to which they should ask questions; when they should accept answers and stop asking questions; and when they need to explore more deeply. This should be considered on a matter-by-matter basis for issues a director identifies that may need the help of an independent advisor. It also should be considered periodically as part of the board's continuing education process. 

• Authorize a Standing Committee to Oversee Enterprise Risks. Boards should delegate to a standing committee, or constitute a new standing committee with authority on behalf of the board to investigate, assess and take appropriate action with respect to risks of the organization's enterprise. To facilitate the exercise of this authority, a board should require the organization's management, including each of its executive officers, to report such risks to this oversight committee and to meet at least annually with the committee in executive session.

• Annual Review of the Roles and Responsibilities of Board Committees and Committee Charters. All organizations need to review their committee charters to ensure that such committees have the requisite authority necessary to complete its delegated tasks and additionally to ensure that such committees do not have authority greater than what the full board desires to grant Committee charters are often the most ignored governing document for any organization. The charter of any committee should be discussed, if not negotiated, between the directors who are on the committee and the remaining directors who will rely on the committee on an annual basis. A charter not only protects non-committee members from liability, but also imposes that liability on the committee members. For directors, state law allows them to rely upon a committee of directors of which they are not members. However, a director may rely upon a committee only for matters within the committee's designated authority and the committee has a legal duty of care to carry out that authority as an ordinarily prudent person in a like position would do under similar circumstances and a legal duty of loyalty to do so only in, or not opposed to, the best interest of the organization. Thus, it is imperative that the authority of a specific committee is properly and clearly designated in its charter. 

• Best Practices Audit. Most organizations have their financial statements audited on a yearly basis. However, very few conduct an audit, either formal or informal, of its corporate governance practices. A yearly audit of governance practices goes a long way in creating a productive board and ensuring your board is operating effectively. 

• Board Evaluations/Individual Director Evaluations. Boards must strive for commitment to excellence in corporate governance and not just adhering to minimum standards prescribed by law. This is especially true in today's environment and requires a goal of continuous improvement. Similar to evaluating the organization's chief executive officer, executive director and management for the organization's performance, the board must evaluate itself to constantly improve. A yearly board evaluation will allow an organization to: 

• Check progress against mission and goals Give directors a meaningful measure of accountability 
• Allow for a check of strengths and weaknesses 
• Emphasize the accomplishments of the board 
• Provide a yardstick with which the goals of the coming year can be measured; 
• Encourage teamwork approach to decision making; and 
• Give a feeling of accomplishment 

• Board Composition/Succession Planning. Succession is critical to the life of any organization. As such, one of a board's most important responsibilities is succession of management and the board. A good succession plan helps to prevent staleness on the board. Preventing staleness or "institutionalization" of thought on the board is in the best interests of the organization and its mission. However, adding directors with fresh or non-institutional thoughts comes with a price, whether accomplished through traditional approaches such as term limits or age restrictions or by involving the board in making itself an "expertise" board. Getting your board to buy into a succession plan helps create a multi-generational board that is future oriented and prepared for emergency absences. 

• Update your Organization's Conflict of Interest Policy and Disclosure Process. All nonprofit organizations need to have a well defined conflict of interest policy and disclosure process. A failure in an organization's conflict of interest policy will have an immediate impact on public confidence of any organization in addition to exposing the board to potential liability. 

• Review Executive Compensation. Review and, where appropriate, revise executive incentive compensation arrangements to ensure that they do not encourage executives and others in management to take unnecessary and excessive risks that threaten the value and mission of their organizations. 

What's Next?

Regardless of the cause, the melt down of the for-profit world will directly impact how directors of nonprofit organizations must think, evaluate and make decisions. Whether viewed as an overdue wake-up call or an unfair impugning of the nonprofit director's integrity as a result of the actions of the for-profits, it is important that all directors of nonprofit organizations understand the increased scrutiny on boards and the need for the boards to understand the risks of the organization. This includes understanding and recognizing the state of the environment the organization is operating. The economic crisis is going to have an effect on many organizations that are not interested in making a profit for private inurement. Nonprofits rely on corporate and private donations and interest income from their endowments for programs, operational support and long term sustainability, To maintain and to continue to receive this financial support in these challenging times, organizations need to strive to maintain the public trust and confidence in their operations, financial risk management and direction. 

Directors need to become risk smarter. They need to broaden their view of risk and not limit discussions or analysis only to specific areas of risk This will require directors to evaluate the role of the boards overseeing that there is adequate risk assessment and make changes where appropriate. As the watchdogs for the organization, directors must realize not only that they remain the first and best line of defense against mismanagement and fraud but also that they can be the best line of offense for good management and best practices.

As the new year begins the United States and the world remain saddled with an economic crisis that has not been witnessed in decades. 

A new administration in Washington takes over today, and there still exists uncertainty in how this administration, or Congress, will act to address this crisis in what commentators, and politicians, scream was a failure at the board level to understand and assess the risks of the organization and the boards failure to independently assess management of the organizations. Rumors abound speak of the Democratic Senate considering a bill to federalize fiduciary duties and impose a standard to act with the care that a prudent person acting in a like capacity and familiar with such matters would use -similar to the ERISA standard- as opposed to the state law ordinarily prudent person in a like position would use under similar circumstances. Yet to date we wait to see what the formal response will be.

As a result of the economic crisis, boards of directors will need to respond to unknown challenges and pressures. Boards need to review their past actions in monitoring performance, compliance and risk management—and understand the role they must play going forward. The risk oversight role of the board has never been more critical and challenging than it is today.

In reviewing their role in overseeing risk to the organization, boards need to understand the changes that are likely coming, either through the courts applying new standards or interpreting existing ones, that will directly impact how these boards perform their functions and fulfill their fiduciary duties and likely increase board responsibility for risk management. While the current standard for director liability, established in Delaware by the Caremark case, requires that directors act as reasonably prudent person in a like or similar situation and provides the protection of the business judgment rule, if rumors are true there is real possibility that, as a result of the current economic crisis, boards will need to change how they act. Boards’ decisions will be in the crosshairs and will provide courts with repeated occasions to second-guess board decisions. 

The only certainty going forward is uncertainty. Uncertainty as to the when the recession will end, when the liquidity markets will thaw, when things will return to “normal”—whatever that is. 

One thing that we can be certain of is that there will be some kind of regulatory response to the economic crisis: just as the federal government reacted to the market crash of 1929 with the 33’ and 34’ Acts, just as the federal government reacted to expansion of United States businesses into foreign countries with the Foreign Corrupt Practices Act, and just as the federal government reacted to the Enron and WorldCom scandals with the Sarbanes-Oxley Act. Yes- there will be a regulatory response. But again there is uncertainty as to what the end product will look like. Boards need to be proactive in addressing new risks and new challenges this year will bring. By doing so Boards will be well prepared to handle and adjust to whatever regulatory response comes out of Washington.

The U.S. Court of Appeals for the District of Columbia upheld the Sarbanes-Oxley Act of 2002 (“SOX”) as Constitutional late last week. 

The matter on appeal argued that SOX created unchecked power with the creation of the Public Company Accounting Oversight Board (the “PCAOB”) and in doing so violated the constitution's separation of powers by investing the PCAOB with governmental authority while insulating it from presidential supervision and control. The appeal also argued that the act subverted the president's power over appointments by having the PCAOB members appointed by majority vote of the Securities and Exchange Commission. 

The Washington’s Post’s article on the opinion.

U.S. Court of Appeals opinion

The Delaware Courts have made another strong statement this year in regards to potential director liability. While earlier this year, Delaware took a stance regarding advancement of indemnification for former directors, the Chancery Court recently denied summary judgment to a group of independent directors due to a limited record of the board’s process in evaluating an acquisition offer. In doing so, the Court found that independent directors, acting without conflict, could potentially be personally liable for approving a premium cash offer, with standard deal protections, which was supported by stockholders.

In Ryan v. Lyondell Chemical Co., the Delaware Chancery Court denied summary judgment for the independent directors of Lyondell Chemical Company for breach of fiduciary duties under Revlon regarding the board’s actions during the sale process.

While there are some highlights to address, this blog post cannot provide an adequate summary of the 72 page opinion and the specific facts in the transaction at issue. We will provide a more in-depth summary in the next Acredula newsletter. 

Of particular importance, the offer that was accepted by the Board and Shareholders of Lyondell 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, still the Court questioned the board’s knowledge and efforts to comply with its Revlon duties, even though it found that the board was “active, sophisticated and generally aware of the value of the Company.” Similarly, although the Court found the deal protections to be “typical,” it was not satisfied that the board’s acceptance of the protections was justified by the record.

While this was not a decision after a trial on the merits, there are some key lessons that directors should take away from this opinion to avoid personal liability, as this decision will serve as an invitation to plaintiff’s to seek post-merger litigation and higher settlements where the record is less than perfect:

1. When considering an acquisition, boards should avoid delegating the entire negotiation process to management and should instruct those, outside of the board involved in the process, to keep the board informed of all material contacts and discussion with potential acquirers.
    
2. Absent an auction process or post-signing market check, directors must be cautious to satisfy their duties to maximize shareholder value, even if the agreed upon deal is for a sizeable premium.
    
3. Boards need to create the documentary record of actions taken in response to or in anticipation of acquisition proposals, whether solicited or unsolicited.
    
4. Boards need to follow a deliberate process and establish a thorough record of deliberation, which involves outside financial and legal advisors, regarding its decision on deal protection terms. Specifically in regards to break up fees and matching rights.
    
5. Fairness opinions will not overcome a perception by the reviewing court of a deficient process.

The SEC initiated an administrative action against Mark C. Thompson (“Thompson”) who sat as an outside director on the boards of directors for three public companies during the time that Ernst & Young (“E&Y”) served as the auditor for each company.

In October 2002, E&Y entered into a business relationship with Thompson for the creation of a series of audio CDs designed for business development purposes. The relationship lasted 19 months– during which Thompson served on the board of the three public companies and even sat on the audit committee of one of the companies. E&Y was the auditor for each company during this 19 month time period. As a result of this relationship, E&Y’s independence was impaired and caused each company to lack independently audited financial statements. The SEC determined that Thompson was the cause of each issuer’s reporting violations by “entering into and participating in this independence-impairing relationship, by failing to disclose the resulting conflict of interest, and by signing three annual reports and one audit committee report incorrectly claiming that the companies’ auditor was independent. . .” 

In making the determination above, the SEC ordered Thompson to pay disgorgement of $100,662.33 (his fees director compensation from the three companies) and prejudgment interest of $23,254.94, for a total of $123,917.27 to the SEC. In doing so, the SEC essentially sanctioned Thompson, an outside director, for not being independent. However, to do so the Commission based its finding on the violations of the proxy rules and the periodic reporting requirements, including Rule 14a-9. 

Director independence is at the foundation of corporate governance. As mentioned in our opening post yesterday, one of the basic principles of corporate governance, which comes the basic principle of SOX, “is that the first and best line of defense against corporate mismanagement and fraud is oversight of management by directors independent of the organization with the assistance of independent advisers, including independent audits of financial statements by independent auditors, and with accountability of executives for information provided.” 

While the SEC stopped short of finding violations by the company and the entire board for listing a director in its SEC filings as independent, who was not independent, the SEC has shown that it will police the independence standards and find a way to sanction those who fail to adhere to its mandates. 

This action by the SEC is a strong reminder that all boards must be careful, especially those of publicly-held companies, to pay close attention to its conflict of interests policies, director’s questionnaires, and the disclosures of conflicts by directors. Failure to do so can bring harsh consequences on the directors and potentially the entire board or company.