joseph a. cialone, ii baker botts l.l.p. 3000 one shell plaza 910 louisiana street houston, texas...

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Joseph A. Cialone, IIBaker Botts L.L.P.3000 One Shell Plaza910 Louisiana StreetHouston, Texas [email protected]

Director and OfficerDirector and OfficerLiability InsuranceLiability Insurance

Current DevelopmentsCurrent Developments

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BackgroundBackground

Events over the past two years have focused the attention of government authorities and the investing public on officers and directors of public corporations particularly in

Financial disclosure and reporting

Executive compensation

Corporate governance

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Some of the situations are close to home --– Enron

– Other energy trading companies

Others around the country and in the news --– Tyco

– WorldCom

– Adelphia

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Financial Disclosure Problems

– Revenue Recognition -- Software, etrade

– Earnings management -- Hitting the numbers

– “Cooking the books”

– Acquisition accounting

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Executive Compensation

– Dick Grasso and the NYSE

– The “acid test” of independence

– Public opinion

– Compensation consultants

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– Congress -- Hearings and Sarbanes-Oxley

– The SEC -- New rules, investigations and enforcement actions.

Invariably, and appropriately, the focus of corporate governance centers on the board. Why?


Governmental agencies, the media and others describe these situations as, among other things, “failures of corporate governance” --

– The White House

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Because the directors, as a board, are charged with the responsibility for managing the business and affairs of public corporations.

– The board has that ultimate responsibility —• not the officers--they are appointed by and report to the board; and

• not the stockholders--they own the company, of course, but they have elected the directors to manage their company, ultimately for their benefit.

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Legal FrameworkLegal Framework

Despite the risks, directors do have substantial defenses available to them

Federal law provides a pervasive backdrop, however, primarily through the federal securities laws (disclosure, proxy regulation, etc.), but now most importantly through Sarbanes-Oxley

State law provides the basic concepts of corporate governance, the relationships among the constituents and director responsibilities

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Sarbanes-OxleySarbanes-Oxley

Certification of financial statements by CEO and CFO

Increased disclosures and penalties

Prohibits loans to executives

Forfeiture of bonuses and profits

Increased responsibilities of audit committees, auditors and lawyers

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Question:

Delaware Section 141; TBCA Article 2.31

Fundamental -- The board is legally responsible for the management of the company

What are the legal responsibilities of directors?

State LawState Law

Directors are elected by the shareholders and specifically charged by state corporate law with the management of the “business and affairs” of the corporation, as fiduciaries

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Director ResponsibilitiesDirector Responsibilities

Director duties are fiduciary in nature, derived from trust law concepts.

Directors are the caretakers of other people’s property.

The corporate model places that primary fiduciary responsibility on them, not the management, although they too have fiduciary responsibilities.

What, precisely, is expected of directors?

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Director ResponsibilitiesDirector Responsibilities

Easy to state the general rule under state corporate law:

In discharging its responsibilities, the board and its individual members are expected to act in good faith, to be fully informed, and make decisions or take actions which they honestly believe are in the best interests of the company and its stockholders.

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““Fully Informed”Fully Informed”

A director Should have a working knowledge of the company’s

business and financial condition, its prospects, and its strategic business plan.

Should seek and carefully consider advice and opinions of management and outside advisors, and critically evaluate that information.

Should take as much time as is necessary to review and evaluate materials presented to the board, asking for additional materials or explanations needed.

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““Fully Informed”Fully Informed”

An aspect of the Duty of Care

Importance of process

Reliance on reports and advice of officers

Reliance on professional advisors Common sense/ prudence elements -- time and

commitment are required

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““Good Faith” and “Loyalty”Good Faith” and “Loyalty”

A director must put aside self-interest

Essential element of public trust

Independence is a key element of modern corporate governance

The duty of loyalty

The duty of good faith (a separate duty receiving current attention)

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Independence of DirectorsIndependence of Directors

“Resume” independence

An overarching issue in most corporate governance discussions

– Audit Committees

– Compensation Committees

– Nominating Committees

Definitional challenges -- A variety

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Responsibilities and LiabilitiesResponsibilities and Liabilities

With this focus on the board, directors have increasingly become target defendants in both civil and criminal proceedings

So why would anybody serve as a director or officer of a public company?

– Independent directors now mandated

– But where do you find them?

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Director ProtectionsDirector Protections

Business Judgment Rule Indemnification Exculpation Lawsuit advantages

– Class Actions -- Reform Act (PSLRA)– Derivative Suits -- SLC’s (Special

Litigation Committees) Insurance

But each has vulnerabilities, especially now.

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Business Judgment RuleBusiness Judgment Rule

Provides a presumption of regularity when directors act in good faith, without self-interest, and on a fully informed basis.

Directors have to make an initial showing, and then

Importance of process, reliance on inside and outside advisors, and avoidance of conflicts.

Burden of proof is on the party challenging a decision

Question: How strong is the current presumption?

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IndemnificationIndemnification

State statutes are permissive; most companies convert to mandatory indemnification through charter, bylaw or contractual provisions

Indemnification limited by

– law and public policy (e.g., duty of loyalty, punitive damages, derivative claims)

– financial resources of the company itself (Enron and Adelphia examples)

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The first line of defense Authority to indemnify created by statute Statutes are permissive in most respects,

although indemnification is mandatory when– Wholly successful on the merits or

otherwise– “Otherwise” includes procedural defenses– “Wholly” excludes in Texas partial

successes Statutes distinguish between claims made by

third parties and those made by or in the right of third parties

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Director must meet the statutory standard of conduct to be entitled to indemnification

– Acted in good faith, and– In a manner reasonably believed to have

been in the corporation’s best interests, or

– Not opposed to such best interests in Delaware, and in Texas when director is not acting in an official capacity.

– In the case of a criminal claim, the director must have had no reasonable cause to believe the conduct was unlawful.

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Determination that standards have been met must be made by – a disinterested board or board committee,

or– disinterested stockholders, or

– special or independent legal counsel. Determination need not be made, however, for

advancement of expenses.

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Advancement of ExpensesAdvancement of Expenses

Perhaps the most important aspect of indemnification, and it clearly is the most important at the outset of any claim or lawsuit.

Advancement is permissive unless made mandatory by charter, bylaw or agreement.

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Advancement of ExpensesAdvancement of Expenses

The advancement must be made in conjunction with an undertaking or promise to repay the amounts advanced if it is ultimately determined that the director is not entitled to indemnification.

The undertaking to repay the advancement need not be secured.

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Several ways to make permissive indemnification mandatory

Bylaw or charter provisions– General or Specific– Separate Indemnification Agreements

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Indemnification AgreementsIndemnification Agreements

An indemnification agreement could provide, among other things, the following:

Prompt indemnification to the fullest extent permitted by law against any and all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement of any claim (as defined).

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Prompt advancement of expenses and

reimbursement thereof if it is ultimately

determined that indemnification is not

permissible under applicable law.

A mechanism through which a director may

enforce the terms of the agreement, and

indemnification for the costs of enforcement,

whether successful or not.

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The agreement would impose upon the Company the burden of proving that a director is not entitled to indemnification in any particular case.

The agreement would also provide that the rights thereunder are not exclusive of any other rights to indemnification or insurance to which the director may be entitled, all of which are specifically reserved.

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ExculpationExculpation

Corporate statutes generally permit companies to include in their charters (therefore, stockholder approval required) provisions that protect directors from liability to their corporations for monetary damages except in cases of

– Breach of duty of loyalty or good faith– Other improper personal benefit

– The limits of these statutes have not been fully defined.

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Lawsuit AdvantagesLawsuit Advantages

Securities Fraud Class Actions -- Reform Act– Motions to dismiss frequently granted. – Plaintiffs must be able to raise an inference

that there was actual securities fraud.– But Enron and other corporate scandals

may have reversed this trend, and we will have to watch the courts closely in the coming months.

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Lawsuit AdvantagesLawsuit Advantages

Derivative Suits -- SLC’s

– On behalf of the company

– Special litigation committee procedure developed in Delaware, codified in Texas

– SLC can secure the dismissal of the derivative suit if, after a thorough and independent investigation, the SLC concludes the claims are without merit.

– Again, Enron could affect these procedures.

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InsuranceInsurance

Fills the gaps left by indemnification limitations

But there are challenges to deal with

– Typically covers more than company can

– Cost and coverage

– Not dependent on financial health of the company

– Retentions and exclusions -- definitions

– Application Process -- Rescission

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D&O InsuranceD&O Insurance

Application Process– Sarbanes-Oxley Certifications

– SEC Filings

Restatements -- Undermines application representations

Rescission -- Different legal standards

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– Coverage for investigations

– Definition of “Loss”

– Definition of “Claims”

– Definition of “Dishonesty”

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Typical coverage would involve both individual and company reimbursement

– Coverage A or “Side A” -- directly insures individuals.

– Coverage B or “Side B” -- would reimburse the company for amounts paid to indemnify directors and officers.

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Allocation issues arose when both the company and individuals were defendants

– Insurers developed Coverage C, in part as a response to the allocation fights.

– Coverage C or “Side C” -- insures the company directly for securities claims.

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Recently, problems have arisen in bankruptcy settings

– Debtor claims the policy as an asset of the estate

– Directors claim that they are entitled to the proceeds even if the policy is an asset of the estate.

– With Coverage C, the outcome of that debate is less certain.

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Possible solutions– Side A only

– Excess for Side A only

– Priority of payments provisions– Each solution has its problems

Solution my depend on the purpose of insurance

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ConclusionConclusion

Congress, the SEC, the NYSE, and Nasdaq are now requiring independent directors on boards --

Liability protection is essential, and insurance can fill the gaps left by indemnification and other legal protections

But why would a person agree to serve on a public company board in this environment?

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Joseph A. Cialone, IIBaker Botts L.L.P.3000 One Shell Plaza910 Louisiana StreetHouston, Texas [email protected]

Director and OfficerDirector and OfficerLiability InsuranceLiability Insurance

Current DevelopmentsCurrent Developments

joseph a. cialone, ii baker botts l.l.p. 3000 one shell plaza 910 louisiana street houston, texas...

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state corporate law

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sarbanesoxleystate law

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