Article

DIRECTORS IN THE HOT SEAT: IS IT TIME TO QUIT?
In the aftermath of the numerous corporate debacles in 2001 and 2002, an unprecedented focus is being given to what directors should be doing and how they should be doing it. Congress passed the Sarbanes-Oxley Act of 2002, the SEC and various stock exchanges have proposed and promulgated new rules, shareholders are proposing new governance initiatives, and commentators fill business publications with suggested governance best practices. To the extent this attention results in more proactive and diligent Boards of Directors, the desired result will be achieved and something positive will emerge from the ashes of Enron and other recent disasters.

However, if this corporate governance reform movement simply results in Boards spending more time on procedural requirements at the expense of substantive oversight and planning, unintended erosion in the quality of director performance will likely be realized. As directors react to the changing environment in which they serve, they need to resist the temptation to elevate form over substance in an attempt to create the appearance of proper behavior. The time which outside directors can devote to their directorial responsibilities remains limited (although hopefully increasing). As a result, Board and Committee meetings should be organized with the goal of spending the maximum amount of time on director discussion among themselves and with management regarding important company issues. If defensive procedures dominate the Board’s agenda, the directors may inadvertently be increasing rather than decreasing their risk exposure.

The greatest threat posed by the heightened focus on director performance is the potential for increased liability exposure for directors. The risk/reward equation for directors has been perilously out of balance for many years, with the financial and reputational risks from serving as a director outweighing the rewards. Fortunately, this imbalance has not in the past dissuaded many qualified directors from serving. However, if the risks from director service now significantly increase without a proportionate increase in the rewards from such service, the risk tolerance for many directors may be exceeded, thus resulting in fewer qualified directors being willing to serve. Ironically, this would create precisely the opposite result than intended by the current corporate governance reform movement.

It is still too early to determine if the recent reforms will equate to significantly greater liability exposure for directors. Lawsuits against the directors and officers who were involved in the highly publicized recent corporate debacles are still pending and no court has yet interpreted the Sarbanes-Oxley Act or the regulations promulgated thereunder. However, early indications suggest that the courts, like most others, now view director and officer performance with greater skepticism and will apply higher standards when measuring that performance.

In a highly publicized article appearing in the January 2003 Harvard Business Review, E. Norman Veasey, the Chief Justice of the Delaware Supreme Court, described a noticeable change in the way courts will now review director conduct. Among other things, the Chief Justice stated:

What’s Wrong with Executive Compensation: A Round-table Moderated by Charles Elson, Harv. Bus. Rev., Jan. 2003, at 68, 76, 77.

The Chief Justice is not alone in these observations. Delaware Vice Chancellor Leo E. Strine, Jr. observed in a 2002 article that corporate failures such as Enron "generate increased pressure on courts to examine carefully the plausibility of director claims that they were able to devote sufficient time to their duties to have carried them out in good faith." Derivative Impact? Some Early Reflections on the Corporation Law Implications of the Enron Debacle, 57 Bus. Law. 1371, 1385 (2002). Similarly, Vice Chancellor Strine and Chancellor William B. Chandler noted in a recent paper:

Chandler, Strine, The New Federalism of the American Capital System: Preliminary Reflections of Two Residents of One Small State, http://papers.ssrn.com/abstract=367720.

These comments are particularly significant since they come from jurists in Delaware, where the courts are typically deferential to good faith director behavior and are frequently followed by courts in other states. The sobering reality of these comments is best demonstrated by reviewing recent decisions in the Delaware Supreme Court. Since June 2002, that Court issued written decisions in five cases involving the performance by directors of their fiduciary duties. In all five cases, the Supreme Court ruled in favor of the shareholder plaintiffs and against the director defendants. In doing so, the Supreme Court reversed lower court decisions finding in favor of the directors.

Even the perception of increased liability exposure in today’s tenuous environment can discourage the most desirable directors from serving. In order to remain attractive to director candidates, companies today should implement the following 3-prong strategy, which is designed to enhance the company’s ability to recruit and retain the most effective directors.

The best way to reduce risk exposure is to assure a consistently high quality of performance. Lots of resources are now available which identify various types of corporate governance "best practices." The unique circumstances of a particular company will define the appropriate best practices for that company. To tailor the best program, companies should consider using the help of a qualified consultant or legal counsel, who will bring both fresh ideas and an independent perspective to the task.

A few examples of some best practices which have been useful for many companies include:

Board Evaluations. Virtually every employee of most companies is annually evaluated. But that exercise frequently is not extended to the Board. Directors should consider conducting regular evaluations of both the performance of the Board as a whole and the performance of individual directors. It is not realistic to expect improved director behavior unless areas of improvement are identified through a critical self-assessment.
Meetings. Practices and procedures relating to Board and Committee meetings should be evaluated for improvement. Directors should receive and study materials before the meeting so they are prepared to discuss the issues (not just listen to reports) at the meeting. A director most contributes when he or she engages in debates, exchanges ideas and brainstorms alternatives on an informed basis. The frequency and duration of meetings should be considered to assure adequate and timely attention is being given to Board affairs. The identity of non-director attendees should be defined so the Board receives adequate support without discouraging open dialogue. Occasional meetings of only outside directors are becoming more popular.
Board Structure. The types and responsibilities of Board Committees should be periodically reviewed. Many companies are now adding a Governance Committee, so there is deliberate and continual consideration of governance issues. The wisdom of separating the CEO and Board Chair should be considered, as well as the wisdom of term limits and mandatory retirement.
Director Behavior. One of the primary roles of a director is to exercise healthy skepticism towards management reports and recommendations. Directors should challenge management and be willing to disagree. If answers are not sufficiently complete or satisfactory, the director should push for more information. If a director does not understand something, he or she needs to investigate. Directors should constantly watch for warning signs and appropriately respond.
Education. Directors should regularly include in their Board activities a variety of educational programs unrelated to the specific issues then being considered. Factual, legal and financial information concerning not only the company but also its industry and market should be provided both in initial Board orientation programs and through ongoing educational programs.
CEO Succession Planning. A well-defined CEO succession plan and training program is one of the Board’s most important but frequently overlooked responsibilities. Having a qualified and trusted successor identified in advance not only allows for a seamless transition of leadership in emergency situations, but also gives the Board the freedom to quickly change CEOs when necessary without jeopardizing company operations.
Integrity. The Board should insist upon the highest level of ethical behavior throughout the company. If a director is not confident in the integrity of senior executives, either the director or the executive should leave the company. A policy of zero-tolerance for questionable behavior should be implemented and enforced at all levels of the company.

Fundamentally, the goal of any "best practice" program is to sensitize directors to the fact that they serve in a critically important role and represent a valuable asset to the company. With that mindset, directors will be more inclined to be extra diligent and will apply their own common sense to enhance their performance.

Compensation As the risk of director service increases, the rewards from such service should similarly increase. Although the preferred form of director compensation (i.e., securities versus money) can be fairly debated, it is clear that directors should be paid more today than ever before. This higher level of compensation may vary depending on the director’s responsibilities. For example, members of the audit committee arguably should be paid more in light of their greater time commitment and heightened responsibilities. Ultimately, a company needs to pay directors an amount that is sufficient to induce the most qualified candidates to serve.

Fewer companies now use stock options to compensate their directors, both because the options can quickly become worthless and because investors generally view executive stock option programs with disdain today. A growing number of companies are adopting some type of deferred compensation arrangement in lieu of stock options as a more acceptable means to add incentive for long-term focus by directors. Minimum stock ownership requirements for directors also create the appearance of a long-term perspective by directors.
Insurance Coverage

It is now more critical than ever that companies maintain truly protective insurance for not only its officers, but more importantly its outside directors. Absent that quality protection, it is difficult to imagine why a sophisticated business person would be willing to assume the escalating risks inherent in being a director today. To address this concern, several insurers (including CODA, a subsidiary of ACE Insurance Company) now offer some type of Independent Director Policy, which insures only outside directors (not officers or other employees) for non-indemnified loss. The CODA Independent Director Policy, which is generally recognized as affording the broadest coverage, contains all of the coverage enhancements contained in the standard CODA Directors and Officers Liability Policy, plus several additional enhancements to provide extraordinary protection for the outside directors. For example, the Policy contains no exclusions for fraud, dishonesty, willful violations of law or illegal remuneration. In addition, by insuring only the outside directors, coverage under the policy is not diluted by losses incurred by officers or the company. Some of the broad features of the CODA Independent Director Policy, as compared with a standard directors and officers liability policy form, are summarized in the chart below.

Such a policy, in combination with a company’s standard D&O insurance program, should give the outside directors sufficient confidence that their personal risks from service are well managed and contained, thereby allowing the company to attract and retain the best available directors.