3.7.5 Summary of director liability

Documentgegevens:

Mr. W.J.L. Calkoen, datum 16-02-2012

Datum: 16-02-2012
Auteur: Mr. W.J.L. Calkoen
JCDI: JCDI:ADS600696:1
Vakgebied(en): Ondernemingsrecht (V)

A great many cases come before the Delaware courts, some of which are of great importance. The rulings are clear and swift. The Citygroup and AIG cases are good examples of the law on oversight of risk management.

The Delaware courts make a clear distinction between the standards of (best) conduct and standards of liability. The Disney case is an example of guidance on better procedures in board meetings. The courts do give an opinion about standard of (best) conduct, but without any legal consequence. These "views" of the court, one could call it "preaching", do have effect on corporate governance standards. They mainly give opinions as to liability and these are not based on standard of (best) practices, but on the Business Judgment Rule.

The merit of US law is that by sticking to basic principles such as the business judgment rule and the fiduciary duties of loyalty, including good faith, and due care, as reflected in case law, it can be flexible and yet fitted to the facts of any specific case in a predictable manner.

In hostile takeover cases and in deal protection cases, case law serves as a solid beacon for practising lawyers as well, Unocal, Moran, Revlon, Time Warner and QVC are good examples.

The Federal Securities Laws of 1933 and 1934, amplified by the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, are highly relevant to the dayto-day activities of directors. Especially the Section 11 Securities Act 1933 on prospectus liability cases are a worry for directors and to a lesser extent the Section 10 Securities Trading Act 1934 on regular filings are worrisome as well.

There is a vast legal activity in the US, because first the parties pay their own costs without the loser having to repay the winner for its costs, second the clans action system and third the no cure no pay practice, where the winners' lawyer gets a substantial profit.

US policymakers (lawmakers, rule making institutions, e.g. SEC and judges) realize that it is important to attract good candidates to be directors of corporations and therefore not to make them personally liable to pay out-ofpocket expenses if they act in subjective good faith and do not commit deliberate fraud, collect illegal profits, profit from self-dealing or deliberately neglect their duties. Judges, academies and, above all, external and in-house legal and other counsellors play a very important role in advising boards about best practices and standards of conduct in board processes.

Although outside directors in the US are frequently sued, which is not only very expensive and time consuming but also a source of much anxiety and worry about media exposure for them, they are rarely ordered to pay damages. There are various reasons for this.

(a): Owing to the standards applied by the courts in corporate liability cases, in particular the "business judgment rule" and the duties of "loyalty" and "care", liability exists only in exceptional cases.
(b): As shareholders can attack directors in corporate liability cases only via derivative procedures the procedural hurdles are not easy on the plaintiffs.
(c): Even under Section 11 of the Securities Act, which requires that the company's registration statements when getting listed are without material misstatements or omissions, where the evidence requirements of plaintiffs are the easiest, all directors have a due diligence defence (i.e. "reasonable investigations" and "reasonable grounds"). This is a negligence standard and it is easier to defend outside directors than inside directors.
(d): Under Section 10(b) of the Securities Exchange Act, those responsible for material misstatements or omissions can be held liable while getting listed, the standard for a successful claim by shareholders is not as easy to satisfy as under Section 11 of the Exchange Act. The standard of Section 10(b) is "scienter" and only comes into play when there is a high degree of recklessness with regard to truth, for example where directors fail to investigate reports of problems ("red flags") in their corporation.
(e): Practically all listed corporations include full indemnity clauses in their articles of incorporation, by which the company pays directly or reimburses all expenses, including damage claim amounts and costs of the directors, provided the directors have acted "in good faith and reasonably in the interest of the corporation".
(f): Practically all listed corporations have good D&O insurance policies and there are economical reasons to settle cases at or below the maximum insured value.

The end result of all this is that although there are over 230 federal securities class action cases filed in the US federal courts each year and approximately 140 public companies annually facing lawsuits alleging breaches of corporate fiduciary duty by their directors in the state courts such as Delaware, most of these cases are settled and few come to a final trial verdict. In all settlements and judgments involving large companies, only in the Smith v. Van Gorkom,1 WorldCom and Enron cases and about 10 other cases since 1980 have outside directors had to pay amounts out of pocket.2

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In the end the case was settled by the buyer paying $23 million to the shareholders.

Bernard S. Black, Brian R. Cheffin and Michael Klausner, 'Outside Director Liability: A Policy Analysis', Tourral ofInstitutional and Theoretical Economics (JITE) 162 (2006), pp. 10-11 ('Bleck, Cheffms and Klausner (2006/B)'). Also Bernard S. Black, Brian R. Cheffms and Michael Klausner, 'Outside Director Liability', University of Texas School of Law, Working Paper No. 26 (2004); and Black, Cheffms and Klausner (2006/A), p. 1086.