YET ANOTHER CORPORATE DILEMMA
New federal sentencing guidelines for corporations and other entities convicted of criminal activity became effective November 1, 1991. Since then, much has been written to warn organizations of the Guidelines' rather draconian mandatory fine provisions (which can result in fines as high as $290 million depending on the nature of the offense and the size of the organization's gain or the victim's loss). However, under the new Guidelines this mandatory fine can be reduced dramatically or even eliminated if the company has in place prior to commission of the crime "an effective program to prevent and detect violations of the law." The components of an "effective" compliance program are set forth in a Commentary to the Guidelines. Not surprisingly, the components describe a very comprehensive program far exceeding what most companies currently maintain.
If they have not done so already, companies with U.S. exposures should be promptly consider implementing and enforcing an comprehensive compliance program conforming to the Guidelines. The benefit of such a program is reduction of the company's potential criminal fine exposure, which in turn reduces the director and officer liability exposure that could arise if the company incurs a large fine. Indeed, some respected corporate governance authorities have stated that directors would be grossly negligent if they fail to adopt such a program.
Much of the published materials concerning the new Guidelines, though, ignore the potential risks to the company and its directors and officers if a comprehensive compliance program is maintained. For example:
- The program may created heightened director and officer duties to prevent, identify and respond to illegal activity and thus may cause greater D&O liability exposure. Although directors and officers must make reasonable inquiry into the business and affairs of the company pursuant to their general duty of care, courts have been reluctant to create a D&O duty to monitor for law compliance and ethical behavior. In Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125 (Del. 1963), the Delaware Supreme Court held that there is no D&O duty "to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists." A comprehensive compliance program may create such a duty.
- To the extent to program brings to the attention of company officials illegal activities which would otherwise have gone undetected, the program may place the company officials in a difficult position by requiring or encouraging disclosure to the government of the illegal activity.
- By creating a corporate policy requiring immediate reporting of all wrongdoing to the government, the program may tend to discourage employee disclosures to and cooperation with company officials.
- To the extent the program results in an internal disciplinary proceeding, a "road may" may be created for criminal prosecutors or civil plaintiffs.
- Under certain circumstances, disclosure of wrongdoing as required by the program may waive the company's attorney-client privilege.
- Internal investigations pursuant to the program may be discoverable and may give rise to employee allegations of defamation, discrimination or violation of Fifth Amendment or other rights.
The new Guidelines place companies and their executives in a difficult dilemma. Although adoption of a comprehensive compliance program can significantly benefit the company if convicted of a federal crime (and indeed may be required by the directors' fiduciary duties), such a program will likely create additional or heightened duties, risks and liability exposures to directors, officers and others involved in the program.
A possible compromise of these competing interests would be to structure a compliance program aimed primarily at crime prevention. With regard to crime detection, the program could require only internal identification and mitigation, but not reporting to the government. The Guidelines evidence and attempt by the federal government to deputize directors and officers for purposes of crime detection. D&Os need not and arguably should not voluntarily accede to that attempt by adopting an overly broad compliance program.
In summary, companies cannot afford simply to ignore the Guidelines, but should carefully consider their impact and the need for responsive action. Any compliance program implemented in response to the Guidelines should reflect not only the unique characteristics of the particular company and its industry, but also reflect an analysis of both the benefits and risks of the program.
DEFENSE COST MANAGEMENT
When structuring a D&O risk management program, few corporations adequately focus on issues relating to the advancement of defense costs by the corporate and the D&O insurer. Because D&O claims can last years and result in millions of dollars in defense costs, a clear understanding of how these costs are to be funded pending ultimate disposition of the D&O claim is essential.
Under virtually every state indemnification statute, a corporation may indemnify its directors and officers only after a determination that the D&Os conduct satisfied designated standards of conduct. For example, under the Delaware statute, directors and officers must have acted "in good faith and in the reasonable belief that their conduct was in, or not opposed to, the best interest of the corporation." Since this determination usually cannot be made until completion of the claim and full evaluation of all discovered facts, defense costs typically cannot be indemnified by a corporation until the D&O claim is ultimately resolved. Most state statutes, though, permit a corporation to advance defense costs during the pendency of a D&O claim if the defendant director or officer agrees to repay to the corporation the amounts advanced if it is ultimately determined he is not entitled to indemnification. Most corporations mandate this advancement in their bylaws, certificate of incorporation or other internal indemnification provision.
A recent Delaware Supreme Court case highlights how such a mandatory advancement provision can cause unintended and arguably inappropriate corporate liability. In Citadel Holding Corporation v. Roben, 603 A.2d 818 (Del. 1992), a director who was sued by his corporation for violations of Section 16(b) of the Securities Exchange Act of 1934 (i.e. short-swing profit prohibition) sought advancement from the corporation of his defense costs. The indemnification agreement between the director and the corporation expressly stated that the corporation was not obligated to indemnify any liability or expense relating to a Section 16(b) claim, whether or not successful. However, the indemnification agreement, like most corporate indemnity provisions, required the corporation to advance expenses incurred by the director in defending any claim. The Delaware Supreme Court ruled that the corporation was obligated to advance defense costs (even though ultimate indemnification was clearly not permitted) and seek repayment from the director of those advanced costs at the conclusion of the litigation.
The Delaware Supreme Court also ruled that the corporation was obligated to advance not only the expenses incurred by the director in defending the Section 16(b) claim against him, but also the expenses incurred in prosecuting a counterclaim against the corporation arising from the same matters as alleged in the original complaint by the corporation. The court considered this counter-claim as an affirmative defense which triggers the advancement obligation.
In June, 1992, the Seventh Circuit followed the Delaware Supreme Court in broadly interpreting the Delaware, indemnification and advancement provisions. In Heffernan v. Pacific Dunlop GNB Corp. 1992 U.S. App. LEXIS 12595 (7th Cir. 1992), the court held that the Delaware indemnificaiton statute is not limited to claims against D&O's arising solely out of their acts or omissions as directors or officers, but applies to any claim made in whole or in part by reason of the fact that the person was a director or officer. In that case, a former director and shareholder of the corporation sought indemnification and advancement of expenses incurred in a suit by the corporation alleging that he misrepresented material facts when he sold his stock to the corporation. The court found that his status as a director put him in a position where he either learned or should have learned of the material information which he did not disclose when he sold his stock to the corporation.
This broad interpretation of the indemnification stature is particularly noteworthy with respect to defense cost advancement since the court stated that one's right to advancement is separate from and even broader that one's right to indemnification, citing the Citadel Holding case.
These cases highlight the need for corporations to periodically review the scope and terms of their internal indemnification provisions. The legitimate interest of both the D&O's and the corporation should be reflected.
The advancement of defense costs under the D&O insurance policy raises separate issues. The obligation of the D&O insurer to advance defense costs was frequently litigated in the 1980's because many policy forms at that time were silent or arguably ambiguous on the issue. Today, many policies expressly deny any obligation to advance. Relatively few policies contain a broad advancement obligation.
Because most corporations require within the internal indemnification provision broad defense costs advancement by the corporation, lack of advancement in the D&O insurance policy typically impacts adversely only the corporation, not the D&O's personally. A noteworthy exception may apply to policies purchased by a United Kingdom corporation. Section 310 of the Companies Act of 1985, as amended in 1989, arguably prohibits advancement of D&O defense costs by a U.K. company, although the answer is not entirely clear. Thus, from the standpoint of a defendant director or officer there may be far more compelling reasons for U.K. D&O policy to require defense cost advancement than a U.S. policy.
BRITISH AND AUSTRALIAN D&O PROPOSALS
In response to large, well-publicized corporate failures recently in Britain and Australia, both countries have announced proposals to enhance the quality of corporate governance. If adopted, these proposals are likely to increase the expectations for and the responsibilities and liability exposures of directors in those countries.
Britain
In late May, 1992, The Committee on Financial Aspects of Corporate Governance released its draft report after a one year, far-reaching review of British corporate governance issues. The heart of the so-called Cadbury Report is a code of practice for boards of directors covering matters ranging from the structure of remuneration and audit committees and disclosure of performance-related pay to the role of directors in preparing annual financial statements. In many instances, the Report would require officers to defer more decisions to outside directors.
The proposed reforms are almost entirely voluntary. However, the Report recommends that a new listing requirement be adopted by the London Stock Exchange which would require companies to disclose the extent to which they comply with the Report's recommendations and to explain any noncompliance. Because the chairman of the Stock Exchange is a member of the Cadbury Committee, this recommendation is expected to be adopted by the Exchange. Comments to the proposals may be submitted prior to July 31, 1992, after which a final report will be issued.
Australia
A Corporate Law Reform Bill was released by the Australian Attorney General in February, 1992. The three principal areas of proposed reform relate to the duties of directors and officers, loans and other transactions with directors and related parties, and corporate insolvency. With respect to D&O duties, the Bill would increase director duties to a level comparable to U.S. director duties, require increased disclosure of director conflicts of interest, exclude directors with conflicts of interest from board meetings and provide for civil penalties of up to $200,000 on a reduced standard of proof. The Bill fails to introduce a "business judgment rule" as exists in the U.S., despite requests for that protection from the business and legal communities.
The Bill has generated much debate and criticism. In response, the Government has threatened to withhold much needed reforms in the law regarding directors and officers insurance if the Bill is defeated.
In light of these recent proposed reforms in Britain and Australia, it appears that those countries may be following the footsteps of the U.S. which, in response to a perception that inadequate corporate management caused large corporate failures and investor losses in the 1960s and the 1970s, began adopting ever increasing duties and thus liability exposures for directors and officers.
UPDATE: FIDUCIARY DUTIES TO CREDITORS
An article in the October, 1991 edition of The ACE Report discussed the growing number of cases which recognize D&O fiduciary duties to creditors when the corporation becomes insolvent. As that article indicated, the cases recognizing such a duty have not clearly defined when a corporation is sufficiently insolvent to trigger the duty.
The Delaware Chancery Court recently elaborated on the rationale for this duty to creditors and issued some guidance as to when the duty arises. In Credit Lyonnaise Bank Nederland, N.V. v. Pathe Communications Corp., 1991 W.L. 277613 (Del. Ch., Dec. 30, 1991), the court recognized that the closer a company comes to insolvency, the more the equity holders will be willing to "bet the ranch" on high-risk strategies to enhance earnings since the equity holders have little more to lose. Creditors, on the other hand, as well as employees and other parties who have a greater interest in the continued viability of the company, are directly harmed by such high-risk strategies. According to the court, directors should view the corporation as a "community of interest" that is best served when directors:
recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.
By adopting the nebulous "vicinity of insolvency" standard, the court places directors in a very tenuous situation. As a company's financial health deteriorates, the directors' fiduciary duties correspondingly expand to include a responsibility to creditors, as well as stockholders. In this period of economic difficulty for many industries and numerous companies, one could persuasively argue that a large number of companies are now in the "vicinity of insolvency." If this standard continues to be used by the courts, more D&O claims and recoveries by creditors seem a certainty.