Transcript Corporate Governance Issues for Directors – a U.S. Perspective

Corporate Governance Issues for
Bank Directors – a U.S. Perspective
Corporate Governance Program for Directors of Indian Banks
Mumbai, India
December 14 –16, 2005
© 2005 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved.
Heightened Environment
 Heightened scrutiny on directors’ actions in today’s
environment
– Worldcom -- $20 million paid in settlement by independent
directors
– Enron -- $13 million agreement to settle claims against outside
directors
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Directors’ Fiduciary Duty
 Directors’ duties generally established in case law,
particularly from Delaware courts, whereas liabilities
predicated on disclosure obligations arise from statutory
framework
 Fiduciary duty and business judgment rule
– Duty of care: use that amount of care that ordinarily careful and
prudent individuals would use in similar circumstances
– Duty of loyalty: Act in the best interest of the company and its
shareholders with candor, honesty and integrity.
– Business judgments generally respected as long as duty of care
and duty of loyalty discharged in good faith
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The Disney Case
 Concerning the notorious hiring and firing of Disney
president Michael Obits
 Key take-aways:
– In the absence of a conflict of interest implicating the duty of
loyalty, a director will not be liable for making business judgments
in good faith and with due care.
– “Good faith” a fundamental component of traditional fiduciary
duties of loyalty and due care.
– “Deliberate indifference and inaction in the face of a duty to act”
and a “conscious disregard for one’s responsibilities” can
constitute bad faith and result in liability.
– Directors are not required to comply with best practices of
corporate governance in order to avoid liability.
– However, the definition of reasonably prudent director activity will
evolve and be influenced by trends in best practices.
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Statutory Framework for Directors’ Liabilities
 Public companies’ directors should not confuse meeting
fiduciary duties with establishing a defense to liability
under U.S. federal securities laws.
 Statutory sources for director liabilities:
– Section 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 thereunder: a company, its officers and directors could be
subject to claims that the offering document misstates or omits to
state material facts
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Statutory Framework for Directors’ Liabilities
– Section 11 of the Securities Act of 1933
– Any person who signs the registration statement, a director of the
issuer, preparing or certifying accountant, or underwriter, may be liable
if “any part of the registration statement, when such part became
effective, contained an untrue statement of a material fact or omitted to
state a material fact required to be stated therein or necessary to make
the statements therein not misleading.”
– Section 15 of the Securities Act imposes liability on those who
control a person liable under Section 11
– Section 20 of the Securities Exchange Act of 1934 imposes
similar controlling person liability for violation of the Exchange Act
– Rule 144A/Regulation S transactions not subject to disclosure
rules in general, but always subject to anti-fraud provisions
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Statutory Framework for Directors’ Liabilities
 Available defenses:
– Under Section 11 of the Securities Act, a director may avoid
liability if he/she conducted an appropriate investigation of the
information at issue.
– Standard of reasonableness is that required of a prudent man in the
management of his own property.
– “expertized” v. “non-expertized” information
– Under Section 15 of the Securities Act, a director may avoid
liability if he/she had “no knowledge of or reasonable ground to
believe in the existence of the facts by reason of which the liability
of the controlled person is alleged to exist.”
– Under Section 20 of the Exchange Act, a director may avoid
liability if he/she acted in good faith and did not directly or
indirectly induce the acts constituting the violation.
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The Worldcom Case
 Recent Worldcom case against former Chairman Bert
Roberts
– Most important guidance about the “due diligence” defense in
over three decades
– Director reliance on management or outside professionals,
however expert, will likely not defeat liability as a matter of law.
 Facts of the case
– Related to two Worldcom bond offerings that preceded its $68
billion restatement and bankruptcy filing.
– Plaintiffs assert Roberts’ personal liability for WorldCom’s
deficient disclosures – controlling person liability
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The Worldcom Case
– Core issue is the treatment of line costs
– Line costs largest operating expense, accounting for approximately half
of WorldCom’s reported expenses.
– The ratio of line cost expenses to revenue, known as the E/R ratio, is a
well-known measure of performance in the industry and was reported in
WorldCom’s SEC filings.
– Management improperly shifted $771 million of line costs to capital
expenditures for Q1 2001.
– During 2000, WorldCom also released reserves of over $200 million by
reducing the period (from a rolling 24-month period to 90 days) for
which it maintained reserves for expenses incurred but for which it had
not yet received invoices. The released reserves were used to offset
line costs.
– “Red flags”
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The Worldcom Case
– Roberts claimed he was entitled to rely on WorldCom’s audited
financial statements and non-expertized quarterly financial
information
– Rule 176 under the Securities Act: factors relevant to determining
whether conduct meets the Section 11 due diligence standards
– Among them is a person’s “[r]easonable reliance on officers,
employees, and others whose duties should have given them
knowledge of the particular facts (in the light of the functions and
responsibilities of the particular person with respect to the issuer and
the filings).”
– Endorsed the policy underlying Rule 176(e) that “inside” and “outside”
directors are not similarly situated in matters of diligence
– “sliding scale” of director liability under BarChris - lower standards of
inquiry for outside directors
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The Worldcom Case
– However, Rule 176 is not designed to “modify the responsibility of
underwriters and others to make a reasonable investigation” and does
not lower the bar for determining what is a “reasonable” inquiry
– Effect is heightened standard for directors with another relationship with
the issuer “involving expertise, knowledge or responsibility” with respect
to the disclosures at issue.
– Ultimately, what is missing is evidence of active engagement as a
board member
– Even in the case of expertized information under Section 11, reliance
“may not be blind.”
– The existence of red flags creates a duty to investigate; heightened
duty to investigate in the case of non-expertized information under
Section 11 and more focused attention on the “reasonableness” of a
director’s investigation under Section 15
– “[C]onfidence in the company’s existing management and prospects is
not sufficient to prove good faith” under Section 20 of the Exchange Act
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Practical Implications
 Stay informed, ask questions and watch for red flags!
– Director education and evaluation
– All directors need to be as knowledgeable and effective as possible in
discharging their duties as board and committee members
– Ongoing director evaluation: are we adding value for shareholders?
– Risk identification and analysis
– More systematic, company-wide risk management programs
– Internal control a prerequisite to establishing “good faith”
– Improved focus on other structural elements that may prompt fraud
– Revised approach to management presentations
– Require management presentations to systematically identify
operational, execution and other areas of risk.
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Practical Implications
– Review of third-party information and access to “unmediated”
information
– Insights from analysts, rating agency and material press reports,
meetings with significant shareholders and underwriters, analyst
conferences, whistleblower complaints and “hotline” metrics, as well
as material pending issues as part of the SEC comment process.
– Reevaluate reporting lines within the company
– Meaningful monitoring and evaluation of auditor
– Important to establishing the reasonableness of a director’s reliance
on the auditor.
– Documentation
– Effective minutes
– Minutes should reflect some detail about directors’ questions and
perspectives on matters addressed
– Access to more information
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Practical Implications
– Principle areas of risks and potential red flags for board of directors:
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Changes in business trends
Lack of changes in business trends
Bank examination reports
Comparisons with competitors
Reserves and other estimates
Changes in methodologies
Changes in levels
Adequacy of financial disclosure
Aggressive accounting
Friction with auditors
Related party transactions
Code of conduct waivers
Internal audit reports
Period-end transactions
Adequacy of compensation disclosure
Regulatory compliance
Whistleblowers
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Issues Specific for Bank Directors
 FDIC guidance for bank directors
– “Pocket guide for directors” developed to provide directors of
financial institutions with accessible and practical guidance in
meeting their duties and responsibilities in a changing
environment.
– Endorsed by the Board of Governors of the Federal Reserve
System, the Office of the Comptroller of the Currency and the
Office of Thrift Supervision.
 Key points:
– Maintain independence
– Keep informed
– Ensure qualified management
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Issues Specific for Bank Directors
– Supervise management by
– Establishing specific policies for all significant activities, covering at a
minimum:
– loans, including internal loan review procedures
– investments
– asset-liability/funds management
– profit planning and budget
– capital planning
– internal controls
– compliance activities
– audit program
– conflicts of interest
– code of ethics
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Issues Specific for Bank Directors
– Monitoring implementation through mechanisms designed to provide
adequate information to the board, including management reports
covering areas such as
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the income and expenses of the institution
capital outlays and adequacy
loans and investments made
past due and negotiated loans and investments
problem loans, their present status and workout programs
allowance for possible loan loss
concentrations of credit
losses and recoveries on sales, collections, or other dispositions of assets
funding activities and the management of interest rate risk
performance in all of the above areas compared to past performance as well as
to peer groups’ performance
– all insider transactions that benefit, directly or indirectly, controlling
shareholders, directors, officers, employees, or their related interests
– activities undertaken to ensure compliance with applicable laws (including,
among others, lending limits, consumer requirements and privacy laws) and
any significant compliance programs
– any extraordinary development likely to impact the integrity, safety, or
profitability of the institution
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Issues Specific for Bank Directors
– Provide for independent reviews
– Heed supervisory reports
– Avoid preferential transactions
 Overall, the principal responsibility of a director is to
provide business leadership for a company – set the right
tone at the top
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Other Considerations
 Sarbanes-Oxley Act
– Generally speaking, the core sources of liability for directors
under the U.S. federal securities laws did not change with the
enactment of the Sarbanes-Oxley Act.
– The Act has, however, increased responsibility, and public
scrutiny, of directors.
 NYSE corporate governance rules
– Non-U.S. issuers whose securities are listed on the NYSE are not
subject to all of the NYSE’s corporate governance requirements,
and are permitted to follow the corporate governance
requirements in their home countries, subject to certain additional
requirements.
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Other Considerations
 Insider Trading
– Potential liability for directors, officers and their families on the
basis of their possession of and failure to disclose material,
nonpublic information about the company.
 Foreign Corrupt Practices Act
– Prohibits the bribery of non-U.S. government officials and officials
of certain public international organizations and requires
companies to keep accurate books and records and devise and
maintain internal controls.
– Liability attaches to the issuer, its controlling persons and, in the
case of certain offers and payments, the issuer’s officers,
directors, employees or agents or shareholders acting on behalf
of the issuer.
– Subject to criminal penalties, including fines and imprisonment.
– Adoption of compliance policies key to minimizing risk of violation
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Directors’ Duties under English Law
 Common law
– Duty to act in good faith and in the best interests of the company
– Duty to exercise care and skill in the discharge of their duties
– Two fold test – objective and subjective elements
 Statutes
– Company Law Reform Bill: proposed codification of common law
duties; currently being reviewed by Parliament
– Various statutory duties under the Companies Act 1985
– Combined Code on Corporate Governance
– Applies to listed companies
– Not mandatory, but “comply or explain” principle
– FSA: Code of Market Conduct
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