WHO'S THE BOSS?
Highly publicized recent reorganizations of Boards of Directors and senior management have given unprecedented attention to the issue as to whether a company's Chairman of the Board and CEO ought to be the same or separate persons. That issue has no obvious right or wrong answer. However, how the question is answered and how the functions of those two key corporate offices are discharged will have enormous implications to a company's governance culture, direction and success, and thus will either directly or indirectly impact D&O liability issues.
It appears likely the recent publicity given to this issue will induce numerous companies to evaluate the benefits and detriments of having separate persons serve as the company's Chairman and CEO. Some of the relevant considerations in that evaluation include the following:
Accountability. If the positions are separated, will there be sufficient accountability with respect to all aspects of the company? That accountability is clear when one person serves both offices but may become blurred if different persons serve in each office.
Uncertain Authority and Responsibilities. If the two offices are separated, will there be sufficient delineation of the authorities and responsibilities for each office so that both the officeholder and all other company constituents understand their respective roles and no gaps are created between the two offices.
Time Commitment. If an outside director is selected as Chairman, does that person have sufficient time to properly discharge the responsibilities and satisfy the expectations of investors, directors, management and others?
Cooperative Relationship. If a separation of the offices is to succeed, the Chairman and CEO must create and maintain a cooperative relationship evidenced by frequent and frank communications. Anything less will jeopardize the effectiveness of the company's leadership and potentially paralyze both the policy decision-making and operations of the company.
Relationship With Investors. An evaluation of investor expectations, satisfaction and desires should be considered. If there is a greater likelihood of investor discontent or criticism without the separation of offices, compelling reasons should exist if the board chooses not to follow the investors' preference.
Adequate Policy Focus. Absent a separation of offices, will there be sufficient attention given to creative and comprehensive evaluation and identification of corporate policies and will that process have sufficient credibility if the CEO manages the process?
The process of analyzing and debating these issues is a worthwhile goal in itself and in many instances long overdue. More importantly, though, the recent publicity given to these issues may create a unique, and perhaps short-lived, environment in which directors and senior officers are more willing to consider a myriad of other governance issues typically associated with D&O loss prevention concepts. Some of these issues include:
- Defining necessary qualifications or attributes of candidates for nomination to the Board;
- Implementing a director evaluation program to measure the individual and collective performance of the directors;
- Re-examining the appropriate size of the Board and its composition of outside versus inside directors;
- Re-examining which Board committees are appropriate and the responsibilities of each;
- Re-examining the effectiveness of director orientation and ongoing educational/training programs;
- Evaluating the adequacy of various Board procedures, such as the frequency of meetings, advance document distribution, contents of Board minutes and Board meeting attendance by non-directors;
- Adopting or updating the company's emergency management succession plan in the event members of senior management die or otherwise suddenly become unavailable;
- Re-examining the senior management structure, allocation of responsibilities and decision-making procedures;
- Evaluating whether the corporate indemnification provision is truly "state-of-the-art" in light of recent legal concepts and developments.
The risk manager and others who are particularly attuned to D&O liability and loss prevention issues may now have an unprecedented opportunity and arguably an obligation to encourage these broader and equally important issues of corporate governance to be included in any debate concerning separation of the offices of Chairman and CEO.
THE FRIGHTENING REALITY OF SECURITIES CLASS ACTION SUITS
Liability from claims under the federal securities laws is the single greatest exposure for directors and officers today. A recent study be Frederick C. Dunbar, Senior Vice President of National Economic Research Associates, Inc., offers some sobering statistics concerning the severity of securities class action lawsuits. The study, entitled "Recent Trends in Securities Class Action Suits", analyzed recent settlement trends from information gleaned from an established trade publication and an on-line computer data service. The study's conclusions include the following:
The average settlement in securities class action suits has recently increased dramatically. From July 1991 to June 1992, the average settlement was $10.6 million, which included and average settlement of $14.1 million in the first six months of 1992. For the preceding three years, settlements averaged $5.8 million. Even if the four 1992 settlements exceeding $50 million each are disregarded, the average settlement from January to June 1992 was $9.6 million.
If the settlements from January to June 1992 are annualized, 90 cases per year would be settled for total dollar amount of approximately $1.3 billion.
On average, the settlement amount, including payments to investors and plaintiffs' attorney fee awards, approximate 8% of the alleged investor losses.
The percentage of cases dismissed has increased significantly. From July 1991 through June 1992, 8% of securities class action suits were dismissed compared with 2% for the period April 1988 to June 1991. The study fails to note, though, that many of these dismissed cases were simply refiled with an amended complaint which frequently cured the pleading deficiency which gave rise to the original dismissal.
From July 1991 through June 1992, the plaintiffs' bar has made approximately $253 million from the resolution of securities class action suits, representing about 31% of the settlement amounts over the same period. The average plaintiff's attorney fee award in this time period was $3.3 million, compared with $1.2 million for the period April 1988 to June 1991.
A disproportionately large number of securities class action settlements are in suits filed against high-technology firms.
FINANCIAL INSTITUTION D&O's - DO THE BENEFITS JUSTIFY THE RISKS?
The ever-increasing responsibilities, accountability and liability exposure of financial institution D&Os in recent years has been well documented. Beginning in fiscal years commencing after December 31, 1992, yet another layer of regulation is imposed which, in some respects, creates some of the most onerous duties yet on financial institution D&Os. Particularly outside directors of FDIC-insured institutions should now more than ever evaluate the necessity and wisdom of their continued service in light of the respective benefits and risks associated with that service.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") enacted, among other provisions, 12 U.S.C. § 1831m, the stated purpose of which is to "facilitate early identification of problems in financial management through annual independent audits, more stringent reporting requirements, and the establishment and maintenance of internal control structures and procedures." This new legislation applies to FDIC insured financial institutions with total assets in excess of $150 million for fiscal years which begin after December 31, 1992. The newly effective legislation impacts directors and officers primarily in two areas: independent audit committee duties and annual management reports.
Independent Audit Committee
Each institution must have an independent audit committee made up entirely of outside directors. For "large" institutions (currently defined by the FDIC as institutions with more than $500 million in assets), the committee must include members with banking or related financial management expertise, must have access to independent outside counsel (which under proposed FDIC regulations would be prohibited from being retained by the institution itself during the committee's engagement and for twelve months thereafter), and may not include any large customers of the institution. In addition to performing generally recognized audit committee responsibilities, the committee's duties may include:
- Reviewing Call Reports or similar filings for accuracy and timeliness;
- Reviewing the adequacy of internal controls and management's handling of identified material inadequacies and reportable conditions in the internal controls over financial reporting and compliance with laws and regulations;
- Supervising the internal audit function; approving the selection, compensation and termination of internal auditors; approving the scope if internal audits to assure regular testing of the systems and controls associated with preparing financial reports, complying with laws and regulations, and preventing management from overriding the internal control system or compromising the control environment.
In light of this legislation, the duties and thus the liability exposure for members of he audit committee appear to be substantially increased, almost to the point of making committee members guarantors of the institution's financial management integrity and legal compliance.
Annual Management Reports
The newly effective legislation imposes a somewhat similar burden upon senior officers. The chief executive officer and the chief accounting or financial officer of each institution must sign and file with the FDIC an annual report (which must be made available for public inspection) containing:
- A statement of management's responsibilities for, among other things, establishing and maintaining an adequate internal control structure and procedures for financial reporting and complying with the laws and regulations relating to safety and soundness; and
- An assessment of the effectiveness of such internal control structure and procedures and the institution's compliance with the laws and regulations relating to safety and soundness.
By requiring senior officers to assess the institution's compliance with safety and soundness laws and regulations, this legislation may serve as a basis of culpability for the CEO and CFO if the institution at any level violates those laws and regulations. The FDIC in recently proposed regulations identified the applicable safety and soundness laws and regulations to include laws and regulations relating to affiliate transactions, legal lending limits, loans to insiders, dividend restrictions, financial reporting and Call Reports.
Perhaps not coincidentally with the imminent effectiveness of this new legislation, the Office of Thrift Supervision (OTS) issued on November 16, 1992 a press release and guidelines dealing with the responsibilities of directors and officers of federally insured savings and loan associations. The stated purpose of this release was to address the "unwarranted fears of lawsuits" which honest directors and officers may have developed arising from the S&L clean-up and legal action brought against "those who abuse the system".
The guidelines briefly summarize the D&O duties of loyalty and care and identify three categories of claims most frequently made against financial institution D&Os:
- Cases where the D&O engaged in dishonest conduct or approved or condoned abusive transactions with insiders;
- Cases where the D&O was responsible for the failure of an institution to adhere to its own policies, an agreement with a supervisory authority or where the D&O otherwise participated in a safety or soundness violation;
- Cases where the D&O failed to take reasonable steps to respond either to criticisms or directions of the regulatory authority or to advice from professional advisors to the institution.
The real importance of the OTS release, though, is its attempt to comfort D&Os that litigation against them is brought only after a detailed investigation of the factual circumstances and only with the concurrence of the Deputy Director for Regional Operations and Chief Counsel of the OTS. The statement boldly proclaims: "Suits by the agency are not brought lightly or in haste".
Knowledgeable D&Os should recognize that this public relations effort is largely illusory in light of the reality that ever-increasing regulation and liability exposure of financial institution D&Os render service in that capacity today tantamount to combat duty. Officers of institutions presumably understand the enormous risks on their profession today and choose to bear those risks as a cost of earning a living. However, outside directors, particularly members of the audit committee, should seriously evaluate whether the meager benefits from that service justify the mounting risks to their finances, reputation and time.