How to Protect Your Assets
from
July/August 2002
by Eugene M. Propper
Company directors are increasingly at risk from shareholder and other lawsuits—and this problem did not begin with Enron. Today all directors of public companies, particularly in industries where fraud has been often demonstrated—health care, securities, and defense among them—should have concerns about personal liability. Remember, when corporations collapse or have to pay huge penalties, D&O insurance coverage for individual directors may be insufficient, and the personal assets of those directors will be at risk.
Historically, under the “business judgment” rule, board members, like top managers, were required to react only when an actual or potential illegality came to their attention. Not anymore. The Federal Corporate Sentencing Guidelines, which became effective in 1991, set harsh penalties for corporations convicted of criminal actions. This, plus the increase in prosecutions, means that board members and top managers alike have the duty to behave proactively, to try to keep their company and its employees within the law, to avoid these expensive penalties. In other words, they have to ensure that the company has a program that will prevent and/or detect criminal and fraudulent conduct on the part of its employees.
To be sure, even the best-run company may have less-than-honest employees who are able to commit a crime or fraudulent act despite the existence of an active and effective compliance program. If that occurs, are directors liable? Not if the company can show that it has set up an effective compliance program that demonstrates its commitment to legality and if the directors can show their active involvement in trying to protect the company from violating the law. Conversely, companies that continue to adopt a “see no evil, hear no evil” approach may be faced with tremendous costs and penalties because of violations committed by even the lowest-level employees. The business-judgment rule is alive and well, but now its protection must be earned through active investigation, monitoring, and compliance.
A seminal case setting forth the risks directors face is 1996’s In re Caremark International Inc. Caremark, a large health-care company, was indicted for making false claims and for kickback violations. Its shareholders sued the board, alleging that the directors had breached their duty by failing to detect and prevent these violations of the law. Chancellor William Allen of the Delaware Chancery Court agreed. He approved a $250 million financial settlement that included a payment to the shareholders. In a ruling of particular importance to directors, he noted that board members must assure themselves that “information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient . . . to reach informed judgments concerning both the corporation’s compliance with law and its business performance.” Failure to do so, Allen said, “may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”
By any measure, Caremark is a benchmark legal decision. It elucidates for the first time the fact that directors face personal liability to shareholders if the board does not take proactive measures to head off fraud or other criminal behavior. No longer can board members sit back and presume that management, or consultants hired by the company, will take care of all legal and compliance issues. The board members themselves must make active inquiries of management and gain a level of comfort regarding the information systems in place at the company. This means they must educate themselves in the areas of potential concern and liability, legally and factually, that are of significance to the corporation they serve as board members. In addition, they must follow the dictates set forth in Caremark to help protect the corporation and, ultimately, their own reputations and assets.
Eugene Propper is a partner in Holland & Knight LLP. He specializes in internal investigations and white-collar crime. He is the author of Corporate Fraud Investigations and Compliance Programs (Oceana Publications, 2000).
