© 2005 cleary gottlieb steen & hamilton llp. all rights reserved. corporate governance issues...

© 2005 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved.

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

Corporate Governance Program for Directors of Indian Banks

Mumbai, India

December 14 –16, 2005

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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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– 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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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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– 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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– Principle areas of risks and potential red flags for board of directors:– 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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– 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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– Monitoring implementation through mechanisms designed to provide adequate information to the board, including management reports covering areas such as– 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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– 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

© 2005 cleary gottlieb steen & hamilton llp. all rights reserved. corporate governance issues...

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