How Do Today's Rules Affect Me?
The Emerging Company and the SEC:
The Significance of the Sarbanes-Oxley Act
The job of the corporate director has changed dramatically during the past few years. The "old boys' club" of the past is not only passé -- it is illegal! Membership on a Board of Directors was often considered to be honorific; the work was largely offering advice and consent, and the meetings were regularly noted for their camaraderie rather than their rigor, hard work and vigorous dissent.
Triggered by the recurring scandals and egregious frauds being exposed in both public corporations as well as non-profit institutions, the public and stakeholders are demanding that directors be held fully responsible and accountable for directing the organization they have been elected to serve. The Sarbanes-Oxley Act of 2002 signed by President Bush on July 30, 2002, was the most striking response to these public concerns. However, this legislation conferring much tougher regulatory and enforcement powers upon the U.S. Securities and Exchange Commission (SEC) simply marked a sea change in the ethical and legal standards now expected of all public institutions. Specifically, a corporate director is presumed to have control person liability.
Corporate director is a job few qualified persons need. Therefore, upon being invited to join a board of directors, extensive "due diligence" is imperative. This should include examining the minutes of recent and pivotal board meetings, familiarization with pending litigation, and identification of critical strategic, financial, operational and management issues being faced by the organization. This should examine the effectiveness of the internal controls and risk management tools in place. The resolution to indemnify and hold harmless and the directors' and officers' liability insurance policy (D&O) should reviewed carefully by professional counsel; D&O insurance comes in all flavors and sizes and many policies are woefully porous. Upon extending an invitation to join a board, it is now customary good practice for the candidate to be given full documentation addressing all of these questions.
But beyond these structural questions, it is essential to understand the culture of the board. If one is new, this will require in-depth exploratory discussions with other key directors and officers. Obviously, the openness and candor of the Chief Executive Officer is paramount. Is there a climate of trust and respect? Is there encouragement of probing questions and criticism? Are pockets of reticence, evasiveness or secrecy detected? Do back channels of communication flourish? Does a genuine expectation of ethical behavior pervade the organization? What is the authentic source of pride in the work and mission of the organization? And, quite importantly, are one's skill sets the real reason this job is being offered, or is another agenda embedded in the invitation? Is this job -- which I do not need -- truly a job I can undertake with enthusiasm and commitment?
Once one agrees to serve on the board of a public corporation or institution, one has accepted a statutory job description. Being fired is not the most serious consequence of poor performance! A director has an obligation to know what is going on, and to take effective action to correct wrongdoing as well as unsatisfactory performance. Many boards of governance have learned that this can be a heavy, laborious and frequently frightening responsibility. Dissent is an obligation. "I didn't know," "I didn't understand" or "I wasn't familiar with that" are no longer acceptable answers. One helpful admonition is, "The only dumb question is the question you don't ask."
One need not be involved in fraud to be charged and sanctioned for failing to exercise appropriate governance -- a breach of fiduciary duty. Recent cases define quite clearly how the courts are interpreting this responsibility.
The SEC sued former senior officers, directors and auditors of the Chancellor Corporation (Boston, MA) for financial fraud. 1 In settling "administrative cease and desist proceedings against Michael Marchese, a ... outside director," the Court emphasized:
"Marchese was a director of Chancellor from 1996 to June 1999. The Commission found that Marchese acted recklessly in signing Chancellor's Form 10-K for 1998, which contained materially misleading financial statements, and did not fulfill his responsibility as a director to ensure that Chancellor maintained accurate books and records and adequate internal controls."
Thus, this outside director was not accused of participating in or even being aware of any of the fraudulent activities. But his control person liability led the Court to find he had been inattentive and consequently acted recklessly.
In the emerging morass of litigation addressing the Enron 2 debacle, the Court explained:
"Judge [Melinda] Harmon found that the outside directors might be subject to control person liability even though there is no proof of an underlying wrong under Section 10b of the Exchange Act. Under the control person statute, the shareholders' do not have to prove that the directors had culpable knowledge of wrongdoing but only that they were negligent in not investigating financial reports before signing them.
"[U]nder 5th Circuit case law, a plaintiff may assert controlling person liability by alleging that the controlling person had the power to control the controlled person or to influence corporate policy, but the actual exercise of that control need not be alleged, nor does the 5th Circuit require allegations of culpable participation in the alleged fraud," the judge wrote. "Furthermore, while a director's status alone would not subject him to liability ... influence over the direction of Enron would; outside directors' votes relating to corporate business are evidence of their control over Enron."
Again, control person liability is the standard. "[A]llegations of culpable participation in the alleged fraud" are specifically not required; inattentiveness and reckless conduct can constitute a breach of fiduciary duty.
More than 12,000 publicly-traded corporations are subject to SEC regulation and the rigorous requirements of Sarbanes-Oxley. Most of these are not the Fortune 500® companies. Where can the corporate director go for education and guidance?
The National Association of Securities Dealers Stock Market (NASDAQ®) as well as the New York Stock Exchange have established comprehensive Rules of Corporate Governance. These Rules address the importance of Director Education:
"NASDAQ is committed to helping board members understand their governance responsibilities. In that regard, we are partnering with experts to provide opportunities for directors to receive relevant continuing education. One such initiative is an alliance with the National Association of Corporate Directors (NACD) to provide corporate governance educational services to NASDAQ listed companies. The resources provided are practical, nationally recognized programs designed to define director roles and responsibilities, hone board members' financial oversight skills, provide guidance on audit committee structure and processes, and provide strategies for risk oversight. In addition, NASDAQ sponsors the Board Governance Series of webcasts, produced in conjunction with Corporate Board Member magazine, which is available free of charge at http://www.nasdaqnews.com." 3
While both personal qualification and technical expertise as well as proper structural organization of the board are indeed prerequisites for proper governance, in too many cases these attributes have been found to be inadequate. Jeffrey A. Sonnenfeld offers an insightful examination of the question, What Makes Great Boards Great. 4 He stresses, "The key isn't structural, it's social. The most involved, diligent, value-adding boards may or may not follow every recommendation in the good-governance handbook. What distinguishes exemplary boards is that they are robust, effective social systems.
"... independent directors, audit committees, ethical guidelines, and other structural elements ... can help ensure that a corporate board does its job. Without a doubt, these good governance guidelines have helped companies avoid problems, big and small. But they're not the whole story or even the longest chapter in the story. If a board is truly to fulfill its mission -- to monitor performance, advise the CEO, and provide connections with a broader world -- it must become a robust team -- one whose members know how to ferret out the truth, challenge one another, and even have a good fight now and then." 5
The good news is that -- with proper respect and education -- the job of director of a public corporation or institution has never been more challenging and fulfilling. Today, there is no way a responsible director can not have a crucial impact on the direction of the organization.
1 Securities and Exchange Commission v. Brian Adley et al. (United States District Court for the District of Massachusetts C.A. No. 03-10762 MEL) April 24, 2003.
Andrews Corporate Officers and Directors Liability Litigation Reporter, March 24, 2003. [Return]
2 Re Enron Corp. Securities, Derivative & ERISA Litigation, No MDL-1446 (S.D. Texas March 12, 2003) - See 258 F. Supp. 2d 576. [Return]
3 Summary of NASDAQ Corporate Governance Proposals as of September 10, 2003. [Return]
4 Sonnenfeld, Jeffrey A., "What Makes Great Boards Great," Harvard Business Review, September 1, 2002. [Return]
5 Ibid. [Return]
We are pleased to acknowledge the constructive contribution of the Directors Roundtable through its program, "Key Issues Facing Boards of Directors: The Revolution in SEC Disclosure & Enforcement" on Wednesday, December 10, 2003, in Boston, Massachusetts USA -- Moderator: Beth I. Z. Boland, Esq., Partner, Bingham McCutchen LLP, Boston, Massachusetts Email: firstname.lastname@example.org
Chairman of the Board
Your comments and suggestions for these pages are most welcomed!
Revised: December 15, 2003 TAF
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