Seven Questions to Ask Your Own Attorney Now
from
July/August 2003
by Randy Myers
Christine Jacobs is a realistic risk-taker: She’s the chairman and CEO of Theragenics Corp., a biomed company that trades on the New York Stock Exchange, and an independent director of two other NYSE-listed corporations—health-care service provider McKesson Corp. and radiation detector Landauer Inc. So even though high-profile accounting scandals and their regulatory fallout have boosted the risk of serving on corporate boards, Jacobs is staying in the game—but under her own rules.
Before joining a board, she will ask Rick Miller, an attorney at Powell Goldstein Frazer & Murphy in Atlanta, to run a background check on the company. As he did when she joined Landauer, Miller will comb through its financial statements for signs of potential trouble, apprise Jacobs of outstanding lawsuits or other pending liabilities, review the personal histories of the top executives and other board members, and read what’s been published about the company in the media. If he finds anything questionable, he may then use online databases, Securities and Exchange Commission filings, and Internet search engines to inspect other boards the directors sit on. He will learn how those companies are performing financially, and whether they’re involved in any material litigation. “All these things we’re looking for can raise red flags about whether you want to be publicly put in the same basket as those people,” he says.
Miller adds that he also reviews a company’s press releases for the prior year or two “to see whether they are chock-full of helium.” So far, he says, he has unearthed no nasty surprises on behalf of Jacobs, but in one instance what he dug up helped another client decide against joining a board. “This company was not performing very well,” Miller recalls. “Earnings were in a declining mode, the stock price was being shellacked quarter after quarter, and yet you saw a lot of forward-looking statements saying the company was about to turn the corner.”
Miller’s caution is widely shared by directors and potential directors. “There is no question there is significantly more scrutiny being exercised now by individuals before they join a board,” says attorney Steven Barth, a partner in the business law department of Foley & Lardner in Milwaukee. A primary worry, which sitting directors share, is what board service will mean in terms of their personal liability.
“The fundamental rule of liability for corporate directors has not changed,” says Miller. “We have a business-judgment rule which is law in all 50 states, and if directors exercise due care, the courts will not second-guess the action of the directors.” But, he says, the Sarbanes-Oxley Act and other new regulations have much more stringently defined what is meant by due care. Moreover, regulators, shareholders, and plaintiffs’ attorneys are scrutinizing boards more closely than ever, alert for even a whiff of impropriety or lax attention to fiduciary duty. Attorney R. Mark Keenan, co-chair of the financial services insurance coverage group at Anderson Kill & Olick in New York City, says directors now face “more duties, more restrictions, and more requirements—and each new duty, each new restriction, and each new responsibility is the basis for a claim.”
Rather than rely solely on the advice of a company’s in-house counsel, more and more board members are consulting lawyers of their own to learn how to protect themselves. Among the major concerns for sitting directors are those tighter rules put in place by Sarbanes-Oxley. They include a prohibition, with few exceptions, against authorizing company loans to CEOs and other top executives, and a requirement to set up a system in which whistleblowers can report complaints anonymously. Guidelines for serving on an audit committee are stricter too. Sarbanes-Oxley charges the audit committee with direct responsibility for hiring a company’s outside auditors and overseeing their compensation and scope of work. The act also sets new rules for who can serve on an audit committee; none of the members can be officers, insiders, or paid consultants to the company, and at least one must be a “financial expert” as defined by the SEC.
Attorneys are urging director-clients to be sure their companies move quickly to conform to the new rules. Many are also advising board members to take extra steps—for example, not only to stop approving loans to executives but also to stop forgiving outstanding loans; not only to reshape the audit committee but also to hire their own independent lawyers or accountants to review the financial reporting. (For more, see “Independent Experts Emerge as the Board’s Best Friend,” www.boardmember.com/ issues/2003_1/.) Attorney Ira Raphaelson, a partner at O’Melveny & Myers and co-chair of the firm’s white-collar and regulatory defense group in Washington, D.C., suggests that particular attention be paid to policies on stock options, offshore transactions, special-purpose entities, and anything involving special tax treatment.
Here are seven key questions that people who are considering joining a board should ask their attorneys. Sitting directors can use the questions as a checklist to gauge what to demand from a company to stay on its board.
1. Are my assets covered?
No question is likely to be more important than this one, regardless of how diligent and honorable a director, other board members, and company officers may be. The answer will determine how well a director is protected if sued. You don’t have to lose a case to need such coverage; it costs money to defend even the most frivolous lawsuit. “You have two protections between the plaintiffs’ bar and your house and the assets you want to leave for your children,” cautions Keenan. “One is the indemnification agreement from the company you work for, and the other is your D&O policy.” You should not rely on the in-house corporate legal staff to review them for you, he says: “If you’re an independent director, definitely get your own adviser. You want 100% of their loyalty to you.”
An indemnification agreement is a contract between a company and a director. It specifies that the company will compensate the director for any costs incurred in defending against a lawsuit or similar complaint, or in settling such an action, provided the director has not committed fraud or been found grossly negligent. Of course, a company’s promise to indemnify its directors could be compromised if the company became insolvent, perhaps owing to the very activities that provoked the lawsuit. That’s one reason most outfits also carry directors’ and officers’ insurance; it passes the risk and responsibility for indemnification on to a third party.
Unfortunately, merely knowing that a company provides D&O insurance isn’t enough. Directors should also want to know what exclusions are in the policy and whether the amount of D&O coverage is appropriate for the company’s size and the risks inherent in its line of business. (See “Is Your D&O Good to Go?” on page 84.) “You need to know the nature of the insurance policy the company has purchased,” says Raphaelson. Ultimately, he warns, if you’ve exercised all the diligence that you can as a board member and a plaintiffs’ attorney decides he’s going to sue you anyway, the clauses in your D&O policy had better not have loopholes that force you to finance your defense on your own. Uncomfortable with a company’s D&O coverage? Consider spending some of your own money on supplemental liability insurance.
2. Are the fuzz snooping around?
Clearly, a company being probed for suspected wrongdoing poses an immediate risk to prospective directors. Your lawyer will have the staff, time, and resources to ferret out investigations that are under way but haven’t yet been announced or hit the media. “I use the term ‘investigation’ very broadly,” says Raphaelson. “It would include investigation by federal law enforcement and federal regulators—not just criminal, civil, or administrative investigations—as well as investigation by state attorneys general.”
Adds Miller: “Life is too short to drink cheap wine or join boards currently undergoing intense scrutiny. You ought to wait until it works out; you don’t need the headache.”
That’s fine, if you have the luxury of just saying, “No, I decline to serve.” But what if you’re already on a board and get wind of a pending investigation into the company? In that case, better consult your personal attorney. Miller, for one, advises sitting directors not to walk away. “If you have liability, just bailing off the board isn’t going to get you unstuck,” he says. “The best thing you can do under those circumstances is stay the course and exercise your duties to the fullest extent.” Your attorney can help you decide what notes to take, what documents to save, what objections to raise, and what statements to put on record in the board-meeting minutes in order to best protect yourself.
3. Will I wake up in the morning and regret the company I’ve kept?
The integrity of a company’s officers and board may be the most important factor in limiting risk for individual directors. To be sure, you could do background checks yourself. Most federal court records are accessible to the public at the PACER website run by the Administrative Office of the U.S. Courts (http://pacer.psc.uscourts.gov), and news of criminal investigations by the Department of Justice and the SEC can be found at their respective websites (www.usdoj.gov and www.sec.gov). But you’re better off turning the task over to the pros. Your lawyer will know who they are. The investigators law firms use have sources and contacts that go beyond the public domain, and you can take what they turn up into account before deciding whether to join a board. If you’re already on a board and aren’t comfortable with the background data you’ve been given about a prospective director or company executive, you may want to ask your attorney to run an independent check. More than a hangover is at stake here, if you get mixed up with the wrong crowd.
4. Does the company give good governance?
Again, this is something you can do yourself, but it’s wise to play safe and ask your lawyer to go over the company’s governance bylaws. Do they include guidelines specifying what qualifies a director as independent? Do they mandate that the board have a corporate governance committee? Does the company have a code of ethics, and if so, does it communicate that code in a meaningful way throughout the organization? Does the company spell out its whistleblower policy and the role of directors under that policy, as it should to comply with Sarbanes-Oxley? Any answers in the negative should give you pause if you’re considering getting on the board. If you’re a sitting director, “no” answers should make you demand reform.
5. Am I walking into another Enron?
Enron’s downfall came largely from deals that didn’t show up on the balance sheet. “If there are a significant number of [such] related-party transactions, that’s a bit of a warning flag,” says Foley & Lardner’s Steven Barth.
The challenge is to find out about such deals if the company or its top executives fail to disclose them. Attorney Martin Bring, chairman of the corporate group at Anderson Kill & Olick, says new disclosure requirements in Sarbanes-Oxley improve the odds that companies will spell out their off-balance-sheet activities. But directors or prospective board members who remain worried should quiz the company and its auditors directly, or have their attorneys do so. If you don’t get your questions addressed to your satisfaction, you should reconsider the matter of joining the board, says Bring. If you’re already a director and your questions aren’t satisfactorily answered, you should take your concerns to the full board. With your attorney’s help, you might want to put all your questions about related-party transactions in writing and request that the company respond in kind. Doing that, Bring says, would help you avoid being implicated in the event of an Enron-like fraud. “If a director documents the due diligence he’s done—and doesn’t find these things out because the company doesn’t tell him, even though he’s asked the right questions—his liability is going to be very limited,” says Bring.
6. What booby traps are waiting for me in the footnotes?
You should read these as carefully as you read all other financial data the company puts out. “Just by reading the footnotes to the financial statements, you can learn a lot—if there’s been appropriate disclosure,” Barth says. Warning signs include references to significant amounts of off-balance-sheet debt or any litigation that puts the company at significant risk.
But what if there hasn’t been public disclosure of such dangers, perhaps because it wasn’t required? All the more reason to put an experienced lawyer on the case. Bring recalls a client who several years ago asked him to look at the financial statements of a bank that had invited the client to join its board. Bring scoured the institution’s financial statements and fine print, and also sought out documents about “the quality of their loan portfolio, which, it turned out, was heavily concentrated in one area. I told him that the concentration was not a good thing, given that the market seemed to have been turning against it at that point in time,” says Bring.
The client listened and decided not to go on the board. Within a year the market had tanked in the area where the bank was so exposed. It was taken over by the FDIC and liquidated, and all the directors got sued. Bring says that the makeup of the loan portfolio wasn’t available in public records, but was in a report that the company had been required to file with banking regulators. Bring had requested the report from the bank—and the bank complied. His knowledge of where to scout out danger signs kept his client out of trouble.
7. Are there any pending suits that can cost the company and me money?
When HealthSouth Corp. was getting hit with a passel of shareholder lawsuits earlier this year, its name dominated business news headlines for weeks amid allegations that the health-care company had overstated profits by more than $1 billion since 1999. But most outfits don’t generate that much ink when they get sued—which is why it makes sense, before joining a board, to ask your attorney to check for and evaluate lawsuits against the company. Before re-upping as a director, you should also ask him or her to check out outstanding lawsuits against the company to see how damaging they might be. Top management could give you such information, but better play safe and use a lawyer.
Common sense dictates that prospective or sitting directors should be wary of serving on the board of any company that is in an “at risk” industry, such as tobacco, or is issuing press releases that, in Miller’s words, announce that the company “is losing record amounts of money” but has nonetheless “turned the corner and is hitting on all eight cylinders.” But you don’t need a lawyer to tell you that.
