Click here for printer friendly page

Outside directors in the government's spotlight

Private equity investors who sit on public company boards have long viewed the risk of being sued in shareholder litigation as a cost of doing business, according to Brian Pastuszenski, Jordan Hershman and John Falvey of Testa, Hurwitz & Thibeault. But in the wake of the Enron fiasco and the Sarbanes-Oxley Act, these risks have been considerably heightened and the importance of observing best practices has become all the more clear.

Private equity investors who sit on public company boards have long viewed the risk of being sued in shareholder litigation as a cost of doing business. In the wake of the Enron fiasco and the passage of the Sarbanes-Oxley Act, however, both the SEC and the Justice Department are far more aggressive in asserting and prosecuting violations of federal securities laws. Both agencies are now eager to target outside directors as "gatekeepers" responsible for protecting the investing public against management wrongdoing. This development has dramatically increased the risk of serving as an outside director of a public company and heightened the importance of observing best practices.

Cases Involving Director Self-Dealing. Prosecutors will be especially aggressive in pursuing directors who have engaged in self-dealing at the company's expense. The most notable recent prosecution of a director for personal wrongdoing is the case of Frank Walsh, a former director of Tyco International, Inc. Walsh was charged criminally in 2002 with fraud in connection with his receipt of a $20m "finder's fee" for identifying an acquisition target for Tyco. Tyco's Chairman and CEO had allegedly approved the fee, but Tyco's full board had not. Walsh pled guilty to defrauding the company. He was required to disgorge the full fee (even though at his direction, Tyco had paid half of the fee to a charity), pay an additional $2.75m in fines and serve a term of probation. In settling with the SEC, Walsh agreed to a lifetime bar from serving as a director or officer of a public company.

Failure to Detect Management Wrongdoing. The prosecution of directors who steal from their companies may come as no surprise. But the SEC's current focus on holding outside directors accountable for failing to detect management wrongdoing is a dramatic break from the its historical restraint in bringing enforcement actions against outside directors. Last year, the SEC charged two outside directors of Chancellor Corporation for failing to act on evidence of accounting improprieties (including the resignation of the company's auditors over the issue of the acquisition date of a newly-acquired subsidiary) and signing annual SEC filings without exercising due care to ensure their accuracy. SEC Director of Enforcement Stephen Cutler called the case a "first salvo in the area" of director liability. The Department of Justice also is investigating the matter for possible criminal violations of the securities laws.

Director Liability in the Post-Sarbanes Environment. The SEC's aggressiveness in the Chancellor Corporation matter is likely a harbinger of things to come. In particular, outside directors who sit on audit committees will find themselves at the centre of the SEC's bull's eye due to the audit committee's increased visibility and responsibility in the financial reporting process. By statute, the audit committees of public companies are now responsible for hiring, firing and monitoring outside auditors. Management is now required to discuss with the audit committee, each quarter, any material weaknesses that were detected in the company's internal controls. Audit committees can expect to receive more information from employees suggesting accounting improprieties as a result of the confidential reporting mechanisms required by the Sarbanes-Oxley Act. If there is a serious accounting error, it is likely that the SEC will seek to hold not only senior management responsible, but the members of the audit committee as well.

It is also critical for directors to keep in mind that the SEC has important new enforcement tools after Sarbanes-Oxley - especially a vastly increased enforcement budget and an easier standard to meet in barring a director or officer permanently from holding such positions with a public company. In the year and a half since the Act's passage, the SEC Enforcement staff has taken a sharply more aggressive position on director and officer bars, demanding lifetime bars in situations in which the SEC previously would have been satisfied with a far shorter bar period (or perhaps no bar at all).

Some Best Practices for a Riskier World. In the face of these increased risks, directors should consider taking the following measures:
· Extensive diligence. Members of audit and other board committees should reassess the frequency, length and content of meetings. Audit committees should meet with management annually (with quarterly update meetings) to discuss management's diligence process in connection with required certifications. Audit committees should also assess the completeness of Management's Discussion and Analysis ("MD&A") disclosures, including the "critical accounting policies" discussion.

· Respond to red flags. Board members must act promptly and decisively when confronted with information raising questions about the reliability of the company's financial statements, accounting practices or internal controls. Outside counsel should direct the investigative work so that any information uncovered will be protected by the attorney-client privilege.

· Implement an effective corporate governance program. In the wake of Sarbanes-Oxley, most public companies are implementing codes of ethics. In addition, outside directors should consider having their companies implement an effective "compliance program," which can be thought of as a code of ethics with teeth. Such a program should be run by a compliance officer who reports to a committee of the Board and is independent of management. The program should advise employees of the laws relevant to the company's business, have a mechanism enabling employees confidentially to report violations to the board, and provide for meaningful punishment of violations.

· Re-examine corporate document retention policies. Sarbanes-Oxley raises the stakes for poor document retention/ destruction practices. While document-discard programs are not inherently illegal - and make sense if used appropriately - prosecutors and regulators view them with suspicion. The key is to implement these programs consistently. It is essential that regular document-discard practices be suspended when litigation or a regulatory investigation is foreseeable.

· Follow sensible note-taking practices. Directors and audit committee members should try not to take notes at meetings, and rely instead on the minutes, especially if members feel that they can exercise their duties of care and diligence without taking notes. If taking notes is necessary, directors should review them promptly after the meeting to see if there are any follow- up items or important points that they want memorialized. If not, they should dispose of the notes, consistent with the current prohibitions against inappropriate document destruction.

· Prepare meeting minutes carefully. Minutes should not be a verbatim record of each meeting. They should, however, broadly identify the topics discussed and reflect the active questioning, discussion and attention that committee or board members should display. Minutes should be reviewed by counsel prior to adoption.

· Re-evaluate insurance coverage. To help protect against some of these risks, outside directors should consider having their companies obtain outside director-specific insurance. AIG has introduced new, director-only coverage (known as "Independent Director Liability" or "IDL" coverage) that is available only to the outside directors and cannot be rescinded even if the company's underlying coverage becomes unavailable. Other carriers have now begun to follow AIG's lead.

The years ahead promise intense regulatory and prosecutorial scrutiny of corporate management and board decisions. Adhering to the practices suggested in this article should help optimize the chances of avoiding such scrutiny altogether. At worst, in the event of an investigation, these practices will better enable directors to demonstrate how they fulfilled their duties of care and diligence.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

© Testa, Huwitz & Thibeault, LLP. All Rights Reserved