Governance, Management and Business

·   Failure to implement management controls

·   Failure to cooperate with regulatory authorities

·   Inadequate corporate compliance programs

·   Failure to act on the misconduct of others

·   Poor documentation and recordkeeping of corporate matters

·   Poor auditing procedures

·   Failure to issue required financial reports

·   Inadequate monitoring of management's performance

·   Personal profit or gain from activities as directors or officers

·   Poor administration

Employment Practices

·   Discrimination

·   Sexual Harassment

·   Wrongful discharge litigation

·   Wage and hour disputes

·   Allegations of negligent firing, retention and supervision

·   Failure to provide benefits

·   Alleged violations of federal and state leave-of-absence laws

Unauthorized Actions

·   Inordinate compensation and benefits paid to directors and officers

·   Failure to consult with knowledgeable counsel

·   Excessive dividends

·   Failure to comply with charter and bylaw provisions

·   Illegal political contributions

Conflicts of Interest

·   Using insider information to obtain profits

·   Failure to disclose personal conflicts or interest in business transactions

·   Inappropriate transactions between corporations having common directors

Change-of-Control Situations

·   Insufficient analysis of takeover proposals or threat

·   Failure to exercise due diligence

·   Unreasonable rejection of acquisition offers

Securities-Related Matters

·   Improper communications with analysts

·   Deceptive or misleading representations or statements

·   Improper or insufficient disclosures on financial reports

·   Fraudulent conduct associated with the purchase or sale of securities

·   Illegal profits in stock trading

·   Improper tipping or other misuse of insider information

·   Material misstatements in filings, registration statements or reports

Inadequate Disclosures

·   Inadequate earnings forecasts or reports

·   Omission or misstatement of material facts

·   Conflicts of interest

·   Failure to keep confidential information confidential

Miscellaneous Allegations

·   Consent to improper or illegal actions

·   Failure to disclose questionable or unlawful actions

·   Misuse or mismanagement of corporate assets

·   Fraudulent interstate transactions

·   Intentional wrongdoing

·   Violations of anti-trust laws

·   Lack of good judgment, diligence, or good faith

·   Unauthorized or imprudent loans or investments

An understanding of the many laws which can hold directors and officers personally liable for their actions is a crucial element in determining exposure to loss.

Origin of Liability of Directors and Officers

Understanding the complexities of D&O risk management requires at least a rudimentary knowledge of the basis for and types of liability faced by a corporation's directors and officers. Such liability arises out of acts, errors, or omissions committed by directors and officers while executing their duties in service to the corporation.

The principles upon which D&O liability developed can be traced to the concept of the corporation as a discrete entity. The peace guilds established in England in the 1400s germinated an idea that was to develop into the concept of the modern-day corporation. These early groups consisted of common trade workers and neighbors, loosely banded together for the purpose of providing protection to one another. Out of this crude association, something akin to trade organizations emerged in which craftsmen of similar trades and specialties developed forms of collective governance for themselves.

The concept that business could be regarded as an entirely separate entity was established as far back as the 1500s when the Royal Crown granted the privilege to conduct business as a single body to the Russia Company. Then, as today, the benefit of the corporate form of conducting business was the limited liability afforded the shareholders. The concept is that ownership through stock limits the holder's or investor's liability to a financial amount no greater than the value of the investment. During this period of the formation of trading companies, many unsanctioned companies emerged, competing with and threatening the existence of those chartered by the Crown. Eventually laws were passed in the early 1700s that regulated and limited the formation of corporate entities.

In the United States, beginning in the early 1800s, only a small number of corporate charters were granted by state legislatures, often only after much political maneuvering by those seeking the charter. It wasn't until the late 1800s and early 1900s, amid charges of political manipulation, corruption, and bribery that corporate charter grants were made available to the general public. The states, as the grantors of corporate charters, controlled corporations' existence as legal entities and stipulated the fundamental rules for their formation and continuing existence.

The corporation laws that evolved established the basic premise underlying the corporate entity: specifically that the affairs of the corporation are the responsibility of the board of directors and that, with such responsibility, these individuals may be held personally accountable to the shareholders and others for their actions.

Directors' and Officers' Relationships to
the Corporation

The services of directors and officers to the corporation are generally considered to be rendered in a fiduciary capacity. Just as a trustee is held responsible and accountable for his or her actions, so too are directors and officers, who owe their corporation a duty to exercise their powers in good faith and with prudent judgment. Black's Law Dictionary, 6th Ed, 1991, defines “fiduciary” as “a person having duties of good faith, trust, special confidence and candor towards another” and “a person or institution who manages money or property for another and who must exercise a standard of care in such management activity imposed by law or contract.” Directors and officers also may be considered agents of the corporation, empowered by the shareholders to conduct the affairs of the corporation.

Corporate governance and the responsibilities imposed on the directors and officers have developed as matters of common law, defined by the duties of diligence, loyalty, and obedience. These duties are owed to the corporation, its shareholders and, under certain circumstances, to third parties. While federal and state statutes provide much guidance in establishing standards of conduct, common-law principles are still the basis of determining when wrongdoing has been committed where there is no statutory law.

Directors' and Officers' Relationships to
Outside Organizations

Traditionally, corporations have encouraged or required their directors and/or officers to participate in the management of outside organizations. Frequently outside organizations are involved in civic, charitable, and other not-for-profit causes. Some corporations also may require the outside organization to have a business relationship with the corporation.

In most cases the courts have held all outside directors to identical standards of conduct. However, outside directors having special knowledge or experience relevant to the decision-making process are sometimes held to a higher standard than outside directors without such special knowledge or experience. For example, an outside director who is an accountant by profession could be held to a higher standard than an outside director without such financial knowledge.

The Application of Common-Law Principles

Common law refers to the rules and principles that have developed out of and that have their basis in community customs. Unlike statutory laws that are written and passed by legislative entities, common law does not impose absolute and inflexible rules; rather, common law is subject to the changing interpretations of the courts and is based on principles of equity and public policy.

The personal liability of directors and officers often is a matter of establishing fact, but just as often it is a matter of determining a standard of conduct. For example, the embezzlement or unlawful abstraction of corporate funds may be factually established through financial records as a failure to meet the standard of honesty. However, liability for financial loss to the corporation through alleged mismanagement is less easy to establish and may require the courts to consider certain standards of conduct for which no statutory standards exist. When this is the case, common-law standards of conduct may apply. These standards generally are considered to be based on the following duties:

The Duty of Loyalty

Directors of a corporation have a strict duty of loyalty requiring that conflicts with the corporation's interests be diligently avoided. This duty implicitly requires that directors and officers avoid engaging in activities that might harm the corporation, such as the purchase of an asset in which the corporation might also have an interest. Directors and officers are also required by the duty of loyalty to avoid activities that might be construed as being in competition with the corporation or that may even remotely be construed as involving self-dealing.

In general the duty of loyalty prohibits the corporation's directors and officers from engaging in the following types of activity:

Self-dealing Transactions. These include transactions between the corporation and its directors and officers, or between the corporation and an outside entity, in which the directors or officers might have some financial interest. A conflict may occur when a director or officer has an interest in both sides of a proposed transaction. The potential is that the individual will influence the transaction in his or her favor against the best interests of the corporation. For example, a director may try to influence the decision to award a large contract to a firm in which he or she has an interest, even though the bid was not favorable to the corporation. Other types of self-dealing may not be as obvious, such as when a board of directors of a subsidiary that is not wholly owned by the parent approves a transaction between the parent and the subsidiary that favors the parent over the subsidiary.

Abstraction and Misappropriation of Corporate Property. Not all misappropriation of corporate property is as easily established as theft or embezzlement. Corporate directors and officers are sometimes accused of abusing company perquisites, such as using corporate travel and entertainment funds for purely personal benefit.

The most severe examples of misappropriation are the exploitation or usurpation of a corporate opportunity for personal gain. The duty of loyalty normally would preclude a director from taking advantage of a business opportunity, such as acquiring an asset that the corporation also could have acquired for its benefit. When a director has information regarding opportunities that may be potentially beneficial to the corporation, he or she is bound by the duty of loyalty to bring such information to the attention of the corporation's full board of directors.

Insider trading is a particularly egregious violation of the duty of loyalty. This type of activity is governed by federal laws regulating securities transactions, which generally preclude an evaluation under common law. According to Black's Law Dictionary, 6th Ed., “Insider trading” consists of “Transactions in shares of publicly held corporations by persons with inside or advance information on which the trading is based.”

Corporate Action with Mixed Motives. Probably the most complex questions of directorial loyalty arise in the course of a hostile takeover. Regardless of the board's decision to either fight or accept a hostile takeover, accusations of self-dealing or that the board acted with some mixed motive are common. If a hostile bid is rejected by the board, the directors often are accused of wasting corporate assets in costly takeover defenses to protect their own positions. When a takeover attempt is not challenged by the directors, stockholders often claim the board accepted a bid that was inadequate.

At a minimum, the corporation's directors and officers may be accused of acting with mixed motives involving personal advantage, or charged with an outright breach of loyalty.

The Duty of Diligence and Care

The laws of most jurisdictions require that directors exercise their duties with the care that an ordinary and prudent person would use under similar circumstances and in similar capacities. The suggestion is that the directors and officers are relied upon by the corporation's shareholders to conduct themselves with the same degree of care and with the same diligence exercised in running their own businesses or in conducting the affairs of their families. The duty of care requires that the directors and officers do what is necessary to avail themselves of information needed to make informed judgments and decisions. The duty of care also requires that directors and officers implement appropriate programs to carry out the goals of the corporation and to identify conduct that conflicts with the goals of the corporation.

Although service in the capacity of corporate director or officer might appear to carry a certain risk of personal liability from an easily violated duty of care, successful claims based solely on a breach of this duty are relatively infrequent. The courts have tended to grant directors and officers much discretion in conducting the business of the corporation through application of the business judgment rule. While the extent of protection varies among jurisdictions, the business judgment rule protects directors and officers from incurring personal liability for mistakes in business judgment. Except to the extent that illegal conduct, fraud, or conflicts of interest were present, protection is normally afforded if it is found that decisions were made in the best interests of the corporation. The defense against allegations of violating the duty of care usually must include evidence that the director has made all reasonable efforts to attend meetings, has become knowledgeable and generally educated in the corporation's affairs and decisions, and actively participates in the management of the corporation.

Studies conducted by Harvard professor Myles Mace in the early 1960s and again in the 1980s concluded that directors of medium- and large-size corporations actually did little to represent their stockholders in this fashion. Also, outside directors were found to be somewhat indifferent to educating themselves adequately in the corporation's affairs. While a director is not necessarily expected to devote all of his or her time to a single corporation, the role may require a substantial time commitment.

As the business of running a corporation becomes more complicated, the requirements for directors to meet the standards of care and diligence may increase. The practice of outside directors serving on multiple boards could become so overly burdensome that this practice may become less common. The requirements for officers of the corporation, unless otherwise stipulated in an employment contract or in the corporate bylaws, ordinarily will be for full-time service promoting the corporation and working in its interests.

The Duty of Obedience

Standards of obedience suggest that the corporation's directors and officers execute their duties within the boundaries established by statute and dictated by charter provision. If directors or officers act beyond or outside of the scope of the powers conferred upon them, such actions are referred to as ultra vires acts. The director or officer may become personally liable for such acts and if the board of directors has approved the ultra vires acts, the directors may be collectively held responsible to the corporation.

Corporate protocol also requires certain formalities of operation and conduct. The corporation must be operated as a discrete entity, avoiding any commingling of personal and corporate assets. Failure to comply with the corporate rules and regulations, including the holding and recording of meetings, filing of reports, etc., may void protection provided by the corporate veil, resulting in the directors and officers becoming personally liable for the financial obligations of the corporation.

Application of Federal Securities Law

While common-law principles often help establish the limits and standards of care, loyalty, and obedience that directors and officers owe to the corporation, federal and state statutes restrict and regulate specific conduct. Federal statutes governing the following areas are frequently the basis of actions brought against corporate directors and officers.

The rules governing the organization and operation of corporations were originally regarded as matters of state law. However, many federal rules and regulations now govern the issuance and sale of corporate stocks, bonds, and other securities. These federal rules and regulations are in addition to, and in some situations preempt, any applicable state securities laws.

Following many railroad and mining stock frauds of the late 1790s and early 1800s, most states enacted securities anti-fraud statutes, popularly known as “blue sky” laws. “Blue sky laws” are statutes providing for the regulation and supervision of securities offerings and sales designed to protect citizen-investors from investing in fraudulent companies. The term “blue sky” refers to speculative schemes which have “no more basis than so many feet of blue sky,” according to Black's Law Dictionary, 6th Ed. These laws established state securities commissions to investigate the soundness of new securities issues and to approve or disapprove the offerings. The laws also provided for the general supervision by the appropriate commission or board of all securities sales within the state.

After the stock market crash of 1929 and the rapid growth of interstate commerce, it became apparent to regulators that no single state could deal effectively with securities investments and that country-wide regulation of securities transactions was necessary. In the early 1930s, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. Both Acts sought to combine the common-law protections against fraud with the need to ensure that investors in securities receive the accurate and complete information necessary to make reasonable, informed investment decisions. Some of the provisions of both of these Acts were later modified by the Private Securities Litigation Reform Act of 1995 and the Sarbanes-Oxley Act of 2002. For more information see the discussion of “Private Securities Litigation Reform Act of 1995″, as well as the section on “Sarbanes-Oxley Act of 2002″, which are included later in this section.

The Securities Act of 1933

The Securities Act of 1933 regulates the original issuance of securities. Failure to comply with the Act's provisions can result in both civil and criminal penalties. Under the Act, all but the smallest companies are required to register securities offerings with the SEC. One of the most important provisions of the Act governs the disclosure of information needed by potential investors to evaluate new securities offerings. The required information must be included in registration statements and other publications, such as prospectuses, that are provided as part of a public offering.

Disclosure of Material Information

The Act requires issuers of new securities to provide full and accurate disclosure of “material information” about the offering. Material information typically includes facts about the company's investment, sales, and earnings performance as derived from the company's history. However, material information can also include statements (or omissions) of more subjective opinions and prognostications, if qualified by appropriate warnings and caveats, that inform the investor that the investment is speculative.

Misrepresentation or omission of a material fact in a securities registration statement, whether intentional or not, and whether or not the purchaser relied on the statement, can trigger liability under the Act. Failure to comply with registration statement requirements may result in buyers being able to later rescind their purchases of securities. If the price of the security has dropped, company directors or officers may be required to personally make up the investor's loss. Individuals who can be found personally liable under the Act include the company's Chief Executive Officer, Chief Financial Officer, accounting officer, and members of the company's board of directors. Other “experts,” such as underwriters, accountants, appraisers, or others in whose name and authority the registration statement was prepared or certified, can also be held liable.

The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 contains provisions that apply to both initial securities offerings and to existing securities. The Act imposes rules and establishes guidelines governing periodic disclosure of material information after the initial offering, the proxy process, and insider trading. Persons who commit willful violations of the Act, or who knowingly provide false or misleading information in any filing under the Act (or an SEC rule) may be liable to pay restitution to harmed investors and be subject to injunction and/or civil penalties. Violators may also be liable under other sections of the Act that deal specifically with securities reporting requirements.

Forward-Looking Statements

The Act focuses intently on the formulation and use of what are termed “forward-looking statements.” Such statements establish or affect predictions of future company performance. Information included in forward-looking statements encompasses revenue and expenditure projections, plans and objectives as respects future operations, assumptions underlying or related to any projections of performance, and assessment reports issued by outside reviewers.

Proxies

Under the Act, shareholders must be given a full and fair disclosure of any material facts pertinent to a proxy solicitation and vote. The Act's proxy provisions are somewhat unclear, however, as they do not contain a specific definition of what constitutes a “proxy solicitation.” In the absence of a specific definition, it is unclear what actions related to proxies are subject to the regulations. Corporate officers and directors may be jointly and severally liable for false or misleading information in a proxy statement, even if they did not know the information was false or misleading.

Insider Trading

The Act provides two sets of prohibitions on insider trading. The first is a nearly complete ban on “short-swing profits” generated when an insider buys and then sells (or vice-versa) securities of the company within a six-month time period. This provision only applies to corporate officers, directors, and 10 percent shareholders, who are presumed to have access to corporate information by virtue of their official or financial positions.

The second set of prohibitions applies to insider trading based on material, non-public information acquired through insider access. Such information may be used (or withheld) to defraud outside investors. These prohibitions not only apply to directors, officers and 10 percent shareholders, but other persons (such as senior managers and outside professionals) having access to non-public information as well.

Private Securities Litigation Reform Act of 1995

During the 1980s and 1990s, a trend of securities litigation abuse began to emerge. The increasing cost and frequency of frivolous securities class action lawsuits was making companies hesitant to publicly discuss their future prospects, thus restricting the flow of information needed by investors to make informed decisions. Many of these lawsuits claimed that the directors and officers were jointly and severally liable for the alleged wrongdoing. The frequency of such allegations often resulted in competent persons being reluctant to serve on corporate boards of directors. For a more detailed discussion of Reform Act provisions see also “Private Securities Litigation Reform Act of 1995″ in the Miscellaneous Discussions section of this service.

Some of the more frequent abuses of the securities litigation process that increased the potential liability of corporate directors and officers involved the following:

·   The bringing of private class action “strike suits” against companies by plaintiffs after the value of their stock dropped precipitously. A strike suit is a shareholder-derivative action begun with the hope of winning large attorney fees or private settlements, with no intention of benefiting the corporation on behalf of which suit theoretically is brought. These actions often contained unsupported allegations that the plaintiff was persuaded to purchase the stock by misleading statements about future earnings and/or by the omission of vital information.

·   Use by attorneys of plaintiffs who own a nominal number of shares in a wide array of public companies to file frivolous lawsuits and to serve as lead plaintiffs.

·   The imposition of high discovery costs on defendants, even when class action suits contained frivolous and unsupported allegations, thereby forcing settlements of meritless cases.

In an effort to reduce abusive securities litigation, Congress passed the Private Securities Litigation Reform Act of 1995 (the Reform Act). By passing the Reform Act, Congress sought to help reduce the number of frivolous lawsuits while still protecting investors who were true victims of securities fraud. Also, it wanted to help deter wrongdoing and guarantee that corporate directors, officers, auditors, lawyers, and others properly perform their jobs.

Specifically, the Reform Act was designed to limit abusive securities litigation by doing the following:

·   Creating an incentive for securities issuers to provide relevant information in forward-looking statements without fear of open-ended liability (i.e., a “safe harbor”);

·   Requiring control of litigation by lead plaintiffs that have substantial holdings of the issuer's securities;

·   Removing the financial incentives for becoming a lead plaintiff by limiting the lead plaintiff's compensation;

·   Revising and clarifying pleading requirements to prevent the filing of meritless lawsuits;

·   Preventing the unnecessary imposition of discovery costs on defendants; and

·   Protecting outside directors and others who may be sued for non-knowing violations of securities laws from liability for damages actually caused by others.

In addition, the Reform Act also limits the amount of fees and expenses awardable to attorneys in securities actions, sets standards for audits of securities issuers, and encourages the courts to punish lawyers who bring frivolous lawsuits by creating an opportunity for victims of the lawsuits to recover their attorney's fees at the conclusion of an action.

Safe Harbor Provision

The Reform Act's safe harbor provision protects companies from liability for earnings projections and other forward-looking statements as long as the statements are accompanied by a meaningful disclosure of the important factors that might cause results to vary from those expected. Separate safe harbor standards are created for written and oral forward-looking statements.

If a securities lawsuit is filed, an important component of the safe harbor provision precludes further litigation if a plaintiff fails to prove that the statement—if made by a natural person—was made with the actual knowledge that the statement was false or misleading. If the statement was made by a business entity, the plaintiff must prove that it was made by or with the approval of an executive officer who had actual knowledge that the statement was false or misleading.

Procedural Changes

To limit the use of strike suit plaintiffs, and to increase the role of institutional investors in securities actions, the Reform Act now requires a lead plaintiff to file a sworn statement certifying that he/she (1) actually reviewed and authorized the filing of the complaint, (2) did not purchase the securities at the direction of counsel or simply to be eligible to participate in a lawsuit, and (3) is willing to serve as the lead plaintiff on behalf of the entire class. Further, the plaintiff must identify any other lawsuits in which he/she has sought to serve as lead plaintiff in the last three years.

The Act also limits the amount of the lead plaintiff's recovery to his or her pro-rata share of the settlement or final judgment.

Heightened Pleading Requirements

The Reform Act revises and clarifies securities action pleading requirements. Under the Act, the plaintiff must now specifically “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The Act also requires the plaintiff to first plead, and then in order to prevail, to prove that the misstatement or omission alleged in the complaint actually caused the plaintiff's loss.

Discovery and Liability

In the past, discovery in securities actions could begin as soon as the action was filed. As a result, innocent parties often settled frivolous lawsuits rather than face the high cost of discovery and the uncertainty of further litigation. Under the provisions of the Reform Act, the court now must suspend all discovery proceedings until it determines that the case has merit and should go forward. Early discovery will be allowed only if it is necessary to preserve evidence or prevent undue prejudice to a party. In theory, if fewer securities suits are allowed to proceed to the discovery phase of litigation, the number of settlements made as a means of avoiding payment of large legal fees should be reduced.

Joint and Several Liability

Under prior securities laws, liability could be imposed on one party for damages actually caused by another party. Because of the potential imposition by the court of joint and several liability, directors and officers often felt compelled to settle meritless claims rather than risk exposing themselves to liability for a grossly disproportionate share of the damages in the case.

The Reform Act remedies this potential injustice by establishing a “fair share” system of proportionate liability. Under the Act, full joint and several liability still applies as respects defendants who engage in knowing violations of the securities laws. However, defendants who are found liable, but who have not engaged in knowing violations may be held responsible only for their proportionate share of the judgment.

The Sarbanes-Oxley Act of 2002

Following the Worldcom, Enron, and other infamous accounting scandals, Congress enacted legislation designed to improve the quality of securities financial reporting. The stated purpose of the Sarbanes-Oxley Act of 2002 (the Act) is to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.”

The Act contains a comprehensive set of regulations aimed primarily at those individuals and groups in the best position to ensure or influence the accuracy of corporate disclosures, such as corporate officers and directors, outside auditors and corporate attorneys. In addition, the Act requires the SEC to promulgate guidelines for implementation and enforcement of new duties, responsibilities, and penalties imposed on these regulated individuals and groups.

The following is a brief overview of some of the Act's key provisions.

Audit Committees

The Act creates specific new requirements regarding the composition, responsibilities, and procedures of a public corporation's audit committee. Each member of the audit committee must be an outside director who is “independent” of the corporation. In addition, the corporation's audit committee must:

·   be directly responsible for the engagement and oversight of the corporation's auditors, including resolution of disagreements between management and auditors regarding financial reporting;

·   establish procedures for receiving and dealing with complaints and confidential, anonymous submissions by employees regarding accounting, internal controls, or auditing matters;

·   approve, in advance, all non-audit services (except certain “de minimis” services) provided by the corporation's independent auditors; and

·   receive reports directly from the corporation's auditors on issues related to the audit, such as alternative treatments of financial information under generally accepted accounting principles that were discussed with management and the treatment preferred by the auditors.

The Act thus places a substantial burden on audit committee members to oversee the corporation's auditors, resolve conflicts between auditors and management, and deal with complaints or concerns about the corporation's accounting practices. As a result, audit committees need to reevaluate whether they devote adequate time to their roles. Because of the intense scrutiny corporate reporting will be receiving and the likelihood of being sued for any errors in such reporting, some independent directors may decline to serve on audit committees.

Corporate Responsibility for Financial Reports

The Act directs the SEC to promulgate rules requiring both the CEO and CFO of a corporation to sign and certify in each 10-K and 10-Q report that

·   the certifying officer has reviewed the report;

·   the report (1) does not contain any misstatement or omissions that render it misleading, and (2) fairly presents the financial condition and performance of the corporation;

·   the certifying officers (1) are responsible for designing and maintaining internal controls, (2) have recently evaluated the corporation's internal controls to ensure that material information relating to the corporation is made known to the officers, and (3) have presented in the report their conclusions about the effectiveness of internal controls;

·   the certifying officers have disclosed to the corporation's auditors and audit committee (1) any weaknesses in internal controls, and (2) any fraud, whether or not material, by employees having a significant role in internal controls; and

·   the certifying officers have disclosed whether there were any significant changes in internal controls subsequent to the date of their evaluation, including any corrective actions.

Another section of the Act creates an additional, but slightly different, certification obligation for CEOs and CFOs. Each periodic report containing financial information and filed with the SEC shall be accompanied by a written statement by the corporation's CEO and CFO certifying that (1) the report complies with the requirements of the Exchange Act, and (2) the information contained in the report is accurate in all material respects.

Harsh criminal penalties may be imposed for knowing and willful violations. Although the Act also provides CEOs and CFOs potential defenses for unknowingly certifying false or erroneous financial reports, the strict certification requirements will make it more difficult for these officers to assert ignorance of accounting or reporting errors as a defense. This appears to be somewhat of a reversal of policy for Congress, which passed the Private Securities Litigation Reform Act (the “PSLRA”) less than seven years prior in an attempt to reduce the number of securities fraud actions.

Undue Influence

The Act prohibits any officer or director of a public company to fraudulently influence, coerce, manipulate, or mislead an independent auditor engaged in auditing the company.

Insider Trading

Insiders are now required to disclose trading in the company's securities within two business days of the trade. Insiders also are no longer allowed to defer certain transactions, such as qualifying stock option grants, in the company's securities.

Timely Disclosure

The Act requires “rapid and current” disclosure to the public of material changes in the company's financial condition or operations in accordance with specific rules to be issued by the SEC. Until the SEC publishes regulations defining these new disclosure obligations, companies should consider establishing a general policy on what items and events are considered to be “material” and therefore appropriate for immediate disclosure.

Off-Balance Sheet Transactions and Arrangements

The Act requires disclosure of off-balance sheet transactions, arrangements, and accounting adjustments. Such activities include but are not limited to obligations (including contingent obligations) or other relationships with unconsolidated entities, other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operation, liquidity, capital expenditures, and resources.

Insider Credit Arrangements

Public companies are prohibited from entering into certain credit arrangements with their directors and officers or otherwise renewing, extending or modifying the terms of any credit arrangement in place before July 3, 2002.

Document Retention and Destruction

The Act prohibits the destruction of any document that may be reviewed in connection with a federal inquiry or investigation.

Attorneys

The Act directs the SEC to issue rules setting forth minimum standards of professional conduct for attorneys who appear and practice before the SEC and who represent corporations that are subject to the federal securities laws. The new SEC rules must include provisions requiring attorneys to (1) report evidence of material violations of securities laws, breaches of fiduciary duty, or similar violations by the corporation, or any agent thereof, to the chief legal counsel or the CEO of the company; and (2) to report the evidence to the audit committee (or to another committee of independent board members or to the entire board) if the chief legal counsel or CEO does not “appropriately respond to the evidence” by adopting remedial measures or sanctions.

This provision is controversial because of its breadth and vagueness. It is not clear what kind or amount of evidence will trigger an attorney's disclosure obligation. Nor is it clear how an attorney will determine whether or not the chief legal counsel or the CEO has “appropriately responded” to the evidence. The provision also has the potential to create conflicting obligations for attorneys under federal law and state codes of ethics.

Private Securities Litigation

Under the Act, the statute of limitations for private securities fraud actions filed after July 30, 2002, has been lengthened. The Act increases the limitations period to the earlier of two years after the discovery of the facts constituting the violation or five years after the violation occurred. (The old limitations period was either one year after discovery or three years after the violation, whichever was earlier.) This provision, like the Act's CEO and CFO certification requirements, appears to increase the potential for securities fraud actions.

Employee “Whistleblower” Protection

The Act creates the opportunity for civil action by corporate employees who are discriminated against for providing information to, or assisting in an investigation by (1) a federal agency, (2) a member or committee of Congress, or (3) a person with supervisory authority over the employee. To fall within the protections of this section, however, the employee providing information or assistance must reasonably believe the employer has violated a law, rule, or regulation relating to accounting misconduct or securities fraud. Employees also are protected from discrimination for filing, participating, or assisting in actions or proceedings against their employer for the violation of securities laws or regulations.

Employers considering whether to discipline an employee who erroneously accuses the company of fraud or misconduct will now have to make difficult decisions regarding whether an employee's belief was “reasonable.” In addition, employers will have to carefully consider terminating or taking any disciplinary action against an employee who recently and erroneously reported suspected accounting misconduct to his or her supervisor, even though the contemplated termination or disciplinary action is unrelated to the employee's accusations.

Trends in Securities Litigation

Several studies have been conducted over the past several years on the frequency and economic impact of federal securities lawsuits. One such study conducted by the Law & Economic Consulting Group compared data only for the period April 1993 through September 1996 with data for the period April 1988 through September 1996.

The chart that follows shows the number and percentage of companies sued as compared with the total number of securities issuers in each industry classification (SIC code). The recent study continues to show that the high-tech industries of industrial machinery and equipment (including computers), electronics, and bio-technology firms are the greatest targets of securities class-action lawsuits.

Other trends disclosed by the study include the following:

·   More than 25% of the companies sued were headquartered in California, followed by New York (9.6%), Texas (7.7%) and Massachusetts (6.3%). The high incidence in California is likely the result of that state having the highest concentration of high-tech companies.

·   Companies incorporated in the state of Delaware represented more than half of all companies sued, followed by California (9%) and New York (5.6%). These results are not surprising, since Delaware is the most common state of incorporation.

·   Initial public offerings (IPOs) accounted for more than two-thirds of all securities suits involving public offerings. IPOs account for 14% of all federal securities class-action lawsuits.

·   Average cash settlement and judgment amounts in securities class-action lawsuits have remained fairly constant since 1988. While more than half of all settlements are under $2.5 million, the average of all settlements and judgments is approximately $7 million. Total settlement amounts (including both cash and non-cash awards, where the value of non-cash awards can be calculated) average approximately $8 million during the period April, 1993, through September, 1996. For more information, see “Recent D&O Judgments and Settlements”.

·   Plaintiffs attorneys' fees and expenses averaged $2,187,600 during the period April 1993 through September 1996. This amount is almost 50% higher than the average for the period April 1988 through September 1996. While the study does not provide an explanation for this increase, the rising cost is one of the reasons cited by Congress in support of passage of the Private Litigation Securities Reform Act.

Class Action Securities Fraud Cases

SOURCE: A Study of Class Action Securities Fraud Cases 1988–1996 by Vincent E. O'Brien, D.B.A. Law & Economics Consulting Group: Emeryville, CA. 1995. Reprinted with permission.

Antitrust Laws

The Sherman Act, passed in 1890, was one of the first laws to address and ban restraint of trade and monopolization of business markets. The Clayton Act, passed in 1914 and amended in 1958, modernized the Sherman Act and provided for a civil right of action (e.g., a lawsuit). Corporate directors and officers may be subject to personal liability when their action or lack of action has caused the corporation to violate antitrust laws, resulting in injury to persons or business.

Antitrust-law violations may subject the defendant to treble damages and liability for costs associated with the suit, including reasonable attorney fees. Because many antitrust actions are governed by civil law, the fact that the defendant was acting on behalf of or as an agent of the corporation often is not a defense. The fact that such actions were unintentional, that the defendant acted in good faith, or that such actions were believed to be in the best interests of the corporation is also not a defense.

ERISA Violations

The Employee Retirement Income Security Act of 1974 (ERISA) was enacted to impose a uniform standard for the management of pension plans to help ensure that beneficiaries would receive the prescribed plan benefits at the time of their retirement. The various laws comprising ERISA impose strict fiduciary standards of conduct for plan administrators and other responsible persons. The Act provides for criminal prosecutions and penalties as well as civil recourse.

RICO Act Violations

The Racketeer Influenced and Corrupt Organizations Act (RICO) initially was enacted to eradicate organized crime. While there have been a number of celebrated cases involving the successful prosecution of major criminal elements, RICO also has been successfully used to prosecute directors and officers of corporations by persons whose businesses or properties have been injured through violation of the Act. The definition of what constitutes a RICO violation is very broad, and most of the civil RICO actions have been against otherwise legitimate businesses that allegedly have committed so-called garden-variety crimes, such as mail and wire fraud. A particularly disturbing aspect of RICO is that it provides for the recovery of attorneys' fees and treble damages as a private cause of action, which no doubt has contributed to its popularity and the often-novel approaches employed by plaintiffs' attorneys.

Internal Revenue Code Violations

Corporate directors and officers may be held personally liable for the corporation's violations of tax codes. By law, employers must withhold income and other taxes from employees' wages and are required to remit these amounts to the Internal Revenue Service. Criminal liability can be imposed on corporate officers who are responsible for the payment of such taxes but who fail to do so. Liability also can extend to other officers who have a general control of the corporation's business affairs, such as the directors. When a person is guilty of intentionally failing to collect withholding taxes or fails to remit amounts that have been withheld as tax, he or she may be subject not only to civil and criminal penalties but also may be liable for the amount of the unpaid tax.

Environmental and Pollution Liability

If the corporation violates pollution and environmental-damage laws, the directors and officers may be held personally liable if they participated in the violations or had knowledge that such violations were taking place. Under certain sections of the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), directors and officers may be held liable if they had authority over such acts and could have, but did not, prevent wrongdoing. This test of prevention, if popularly adopted, could broadly expand the potential for personal liability of corporate executives.

For the time being, a more traditional analysis of liability requires that the director or officer personally participated in or knowingly allowed a violation of the Act to occur. While the corporation has been the primary target of pollution-based claims in the past, the firm's directors and officers are frequently and increasingly finding themselves as codefendants in such actions. The trend is that the courts appear to be exempting this class of defendant from the veil of protection historically provided by the corporation. While target corporations, such as waste generators or transporters (and their directors and officers) are often those with a definite exposure, the potential for pollution liability frequently involves property owners who have inherited decades-old environmental problems created by previous owners or occupants of the property.

Application of State Law

State Corporation Statutes

Corporation laws have been enacted in each of the fifty states to govern the activities of directors and officers. Most states also have statutes that define the standard of care that corporate directors and officers are subject to. The laws of each state are unique, but the “duty of care” standard as described in the Revised Model Business Corporation Act of 1984 has been adopted by most states. This standard requires directors to act at all times:

·   in good faith

·   with the degree of care an ordinarily prudent person in a like position would use under similar circumstances

·   in a manner the director believes to be in the best interests of the corporation

In return for such conduct, directors are protected from judicial scrutiny and are largely immune from personal liability, except in instances involving conflicts of interest or dishonesty. Some states may not require an evaluation of conduct against a standard such as the “prudent person” standard. One state requires only that a director discharges his duties as a director, including his duties as a member of a committee, in accordance with his good faith business judgment of the best interests of the corporation. This newer interpretation of the standard of care presumably would protect even incompetent directors, provided they were acting in good faith.

As respects restricted activities, state statutes typically create potential personal liability where directors have:

·   voted for or failed to vote against the declaration of dividends from sources not permitted by law or where the payment of dividends would plunge the corporation into insolvency

·   made unauthorized loans to directors or officers

·   distributed corporate assets to shareholders during corporate dissolution without retiring all debt on other corporate liabilities

State Securities Laws

States typically have laws governing securities transactions in addition to those regulated by federal securities laws. In some cases, the definitions of terms defined in the federal securities acts are expanded by the state courts. Most state securities laws only require securities transactions to be “fair” to the investing public, whereas federal laws require full and truthful disclosure of all material information.

State securities laws are frequently based upon common-law provisions. Common state law requirements as respects securities are (1) a corporate duty to disclose information, and (2) a shareholder's right to inspect corporate books and records, providing the shareholder can show a “proper purpose” for the inspection.

State securities laws sometimes provide grounds for private suits against insiders that are different from those grounds permitted by federal securities laws. For example, most state courts do not place an affirmative fiduciary obligation on insiders to disclose material facts prior to trading unless the insider has a special relationship with the person or company with whom he or she is trading. However, if the failure to disclose goes beyond passive silence, many state laws impose liability.

Although class action securities fraud suits have traditionally been filed in either a federal or state court, passage of the Private Securities Litigation Reform Act of 1995 has resulted in an increase in filings made in both federal and state courts. Where these parallel filings are made, companies may be forced to pay the cost of defending securities actions in both venues, thereby as much as doubling the cost to defend such actions. For more information on the “Private Securities Litigation Reform Act of 1995,” refer to the Appendix.

In addition, if both state and federal laws apply and may be joined, the insider's liability may be as much as doubled. Unlike federal securities laws, many state common-law actions for fraud may also subject insiders to a potential award for punitive damages.

Emerging State Law D&O Exposures

The primary liability exposure for directors and officers has been and continues to be under the federal securities laws. However, while corporations, directors, officers, and D&O insurers are already well aware of these potentially catastrophic federal securities law exposures, far less attention has been given to a recent expansion of liability exposures under state law causes of action.

Largely as a result of the numerous corporate debacles over the last several years, state courts (which are primarily responsible for overseeing state corporate governance laws) are now demonstrating unprecedented antagonism towards defendant directors and officers in a variety of contexts, thereby creating judicial precedent for heightened D&O liability exposure for violations of state and common law fiduciary duties.

This increased focus on state law claims against directors and officers is attributable to several factors:

·   Many state court judges appear to believe that in order to restore public confidence in the corporate governance process, directors and officers need to be subjected to greater accountability. As a result, these judges are now more willing to criticize director and officer conduct than they had been in the past.

·   As a result of the Private Securities Litigation Reform Act of 1995, fewer plaintiff lawyers are being selected as lead counsel in the more lucrative federal securities class-action litigation. Lawyers who are excluded from the securities class-action litigation are now filing tandem state court lawsuits against directors and officers.

·   In order to leverage a higher settlement for themselves, many institutional investors are filing state court claims against directors and officers rather than participating in federal securities class-action litigation.

·   Many of the cases now being presented to state court judges involve bad facts for the defendants. Consistent with the adage that bad facts make bad law, these cases provide a good record for courts to apply a more critical legal analysis and to find D&O wrongdoing.

Some of the recent judicial developments which evidence the increasing importance of state law claims against directors and officers are briefly summarized in the following discussion.

Business Judgment Rule

The Business Judgment Rule is one of the most important defenses for directors and officers in claims for mismanagement or breach of their duty of care. In essence, this defense prohibits courts from second-guessing the quality of the defendants' business decisions, and allows the court to examine only the procedures followed by the defendants in reaching those decisions.

In one case (In re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003)), the Delaware Chancery Court held that the Business Judgment Rule did not protect directors of The Walt Disney Company with respect to allegations that the directors failed to evaluate, negotiate, or approve a lucrative employment agreement with Michael Ovitz, who was a close personal friend of the company's chair, Michael Eisner.

Among the allegations of the plaintiff were that (1) Eisner unilaterally made the decision to hire Ovitz (a close friend of Eisner) as president, despite the protest of three directors who believed that Ovitz did not have the necessary experience; (2) Ovitz' employment proposal, though presented to the compensation committee of the board, did not include detailed information about the employment or compensation terms; and (3) the committee asked no questions about the employment agreement and did not receive a draft of the employment agreement before approving its general terms.

The Court concluded that the directors simply delegated to Eisner the decision to hire Ovitz as president and to negotiate the terms of that employment relationship. According to the Court, the plaintiff's allegations, if true, indicate that the directors did not exercise any business judgment or make any good faith attempt to fulfill their fiduciary duties. As a result, the Business Judgment Rule did not protect the directors' conduct.

By finding the Disney board's approval of Ovitz's employment terms to be “egregious process failures,” the court in essence ruled that the directors can be liable for approving unreasonable employment terms.

In another case (Pereira v. Cogan, 2003 WL 21039976 [S.D.N.Y.]), a New York court interpreting Delaware law found the former directors and officers of a bankrupt privately held corporation liable for breaching their fiduciary duties in connection with compensation paid to the company's CEO. In that case, the Court found the director defendants liable for the company's payment of excessive compensation and illegal dividends to the CEO because the compensation committee that ratified the payments lacked true independence from the CEO, did not seek or obtain outside consultation from an executive compensation expert, and did not review any comparable data regarding the salaries and performance of other executives with similar responsibilities. As a result, the Court determined that the board should not have relied upon a report from the compensation committee that was so obviously insufficient and incomplete.

Because the Court ruled that the directors failed to exercise any diligence in performing their duties regarding compensation, the directors were not entitled to the protections of the Business Judgment Rule, and were personally liable to the company for the illegal and excessive compensation that had been paid to the CEO. According to the Court, directors cannot rely on the Business Judgment Rule to escape liability if they either knew about improper or questionable transactions yet unreasonably failed to take action, or if they did not know about such transactions but should have taken steps by which they would have been informed of the transactions.

Perhaps most troubling is the fact that the Court found not only the directors, but also certain non-director officers, jointly and severally liable for the improper payments to the CEO. Because those officers failed to prevent the wrongful conduct, they were found to have breached their fiduciary duties and, along with the directors, were held liable for the challenged transactions.

Liability Limitation Statute

Virtually all states have adopted statutes that limit the liability of directors and, in some instances, officers under state law. Notably, though, the statutes do not limit or eliminate liability for conduct not taken in good faith or for breach of the directors' duty of loyalty. These state liability limitation statutes, like the Business Judgment Rule, have played an important role in minimizing director liability exposures in state law claims.

Some recent court decisions, however, have eroded the protection afforded by these statutes. For example, in both the Disney and Cogan cases described previously, the defendant directors argued that they should not be liable based upon the Business Judgment Rule, but also based upon their company's respective exculpatory clause for directors in their certificates of incorporation. In both cases, however, the courts found that defense inapplicable because the defendant directors' alleged wrongdoing constituted conscious and intentional disregard of their responsibilities and thus constituted a breach of the directors' duty of loyalty, as well as conduct undertaken not in good faith. Both types of wrongdoing are expressly excluded from the statutory exculpation in most states.

Because the “duty of loyalty” and the conduct “not in good faith” exceptions to the state liability limitation statutes can be rather subjectively applied by courts, it appears clear from these recent cases that courts can easily sidestep this statutory defense by directors if the court is otherwise inclined to hold the directors personally liable.

Independent Directors

A centerpiece to the many corporate governance reforms mandated by Congress and regulators is the heightened expectations for the role of independent directors. Congress has mandated that public audit committees be made up exclusively of independent directors. Several national securities exchanges support the requirement that a majority of directors on public boards be independent and that certain corporate actions, such as the nomination of directors, be approved by independent directors or a committee entirely made up of independent directors.

A critical question when board decisions are subsequently challenged is whether the independent directors who approved the decisions were in fact “independent.” In the past, courts have looked primarily at whether those directors had a direct economic interest in the matter to determine whether they were independent. However, the bar has been raised significantly regarding who can qualify as an independent director. In In re Oracle Corp. Derivative Litigation (824 A.2d 917 [Del. Ch. 2003]), two outside directors on the Oracle Corp. board of directors were selected by the board to serve on a special litigation committee formed to investigate whether the company should bring an insider-trading lawsuit against certain other directors. The Court found that the two outside directors, although they had no economic ties to the company or any of the other directors, did not qualify as independent directors for purposes of the investigation. Rather, the Court concluded that the common ties among the outside committee members (who were both Stanford professors) were so substantial that they created reasonable doubt about the independence of the committee members. In other words, factors other than just economic relationships should be considered when evaluating board members' independence.

It is becoming increasingly more apparent that the courts are viewing director and officer performance with greater skepticism and will likely react to alleged wrongdoing by directors and officers with greater antagonism than they have in the past. Although the overall quality of corporate governance has unquestionably improved in this post-Enron era, the legacy of heightened expectations and responsibilities for directors and officers under state law appears destined to result in higher and higher D&O losses in state law claims.

Federal and State Employment Laws

Today, every business faces not only the traditional challenges of competition and rapidly changing technology, but also a relatively new category of potential adversary—its own workforce. Not-for-profit corporations and public entities, in addition to public and private businesses, are experiencing an explosion of employment-related claims based on:

·Discrimination

·Sexual harassment

·Wrongful discharge litigation

·Wage and hour disputes

·Allegations of negligent hiring, retention and supervision

·Failure to provide benefits

·Alleged violations of federal and state leave-of-absence laws

While the employment relationship is of ancient origin, few laws governing employment existed in the United States until well into the nineteenth century. One of the earliest employment laws was the Civil Rights Act of 1866, enacted following the Civil War to prohibit employment discrimination based on race. But even as laws governing the employment relationship were evolving, the unwritten law of the land for many years continued to be that the employer owed little, if any, duty to its employees. Enforcement of early laws governing employment was sporadic at best, and prior to the development of workers' compensation laws, employees who were injured on the job had little practical recourse. The idea that an employee would expect some form of legal protection was, for much of the workforce, unthinkable.

Passage of the Civil Rights Act of 1964 signaled a dramatic change in attitudes about the employment relationship, and laws governing the employment relationship have been vigorously enforced ever since. Today, relations between employer and employee are governed by a complex and constantly changing body of laws and regulations.

Whether a reaction to the inadequacies of past employment laws, a heightened general awareness of employee and civil rights, or other factors, such as “a new and potent wave of feminism,”^[1] both public and private organizations are being challenged on a broad range of wrongful employment practices. Even the President of the United States is not immune from attack.

The following discussions are a review of some of the federal and state laws that have been codified. These laws reflect society's desire to eliminate discrimination and other wrongful employment practices from the workplace and to guarantee the fair treatment of all employees.