The Top 10 Legal Milestones of the Past 10 Years
from
July/August 2005
by Randy Myers
Ten years ago the stock market was on a bull run that would, for a time, convince many investors that stock prices moved in only one direction: up. In short, life was good. Except that it turned out not to be, of course—not for the shareholders of Enron and WorldCom, who saw billions of dollars of equity disappear when those companies slid into bankruptcy amid massive accounting frauds. Not for shareholders of Adelphia Communications, where members of the founding Rigas family were discovered to have used billions in company funds to enrich themselves. And not for shareholders at other scandal-riddled outfits such as HealthSouth and Rite Aid.
The environment that spawned so many accounting and corporate governance scandals was ripe for reform. The 1990s, observes Delaware Supreme Court Justice Jack B. Jacobs, were “the first time since the 1930s that corporate accounting fraud reached such proportions and had such a nationwide political impact that Congress enacted legislation that established unprecedented corporate governance and accounting-profession reforms at the federal level.”
The changes, federal and otherwise, have been historic.
Corporate Board Member
polled an elite group of attorneys, judges, and academics—see the box on page 50 for who they are—to identify the 10 court decisions, lawsuit settlements, pieces of legislation, and legal trends that have played the biggest roles in reshaping corporate governance over the past decade. Some never made the nightly news. But each played a major part in changing the way board members are—or should be—approaching their jobs.
1. Sarbanes-Oxley and the Federalization of Corporate Law
Among other things, the hurriedly drafted and far-reaching Sarbanes-Oxley Act of 2002 established federal regulation of the accounting profession through the newly formed Public Company Accounting Oversight Board. Former Chancellor William T. Allen of the Delaware Court of Chancery calls this the most important outcome of the act, arguing that audit firms were even more to blame for the lax accounting standards of the ’90s than were corporate boards. But, says Judge Jacobs, the act also created “unprecedented internal corporate governance requirements that hitherto were the exclusive province of the states.” Attorney Harvey R. Miller of Greenhill & Co. adds that it also extended the governing principle of disclosure as the primary means of ensuring responsible conduct by managements and boards of directors.
Whichever outcome ultimately proves most important, it is safe to say that no legal development of the past 10 years has had a more explicit impact on director behavior. As a direct result of Sarbanes-Oxley, numerous corporate boards have had to reorganize to create wholly independent audit, nominating, and compensation committees. They have had to establish whistleblower hotlines to help them uncover unethical or unlawful behavior, and their audit committees have had to maintain closer control over internal and external auditors. Though not expressly required to do so, some boards have gone so far as to install lead directors to counterbalance the influence of CEOs who also serve as chairmen. Most boards are meeting longer and more often, and directors report spending more time preparing for meetings.
Judge Jacobs views Sarbanes-Oxley as a worrisome step in the recent march to the federalization of corporate law. So do many others. “Sarbanes-Oxley, the SEC rules [that enforce it], and the NYSE and NASDAQ listing requirements have intruded in a limited but significant way into the internal affairs of corporations that are the proper and traditional province of state law,” warns former Delaware Supreme Court Chief Justice E. Norman Veasey, who retired from the bench in 2004 and is now a senior partner with Weil Gotshal & Manges in the firm’s Wilmington, Delaware, office. “The issue going forward is the extent to which this encroachment may expand.”
Opponents of federalization argue that state regulation is more conducive to competition and the creation of shareholder wealth. “If one regulator [state] overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire,” UCLA law professor Stephen Bainbridge wrote recently. “In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost.”
2. The Disney Decision: Adding Depth to the Duty of Good Faith
Like most states, business-friendly Delaware, where many companies are registered, holds directors immune from liability for bad business decisions if they make them in good faith using sound business judgment exercised with reasonable care. That “duty of good faith” was loosely defined until a Delaware Chancery Court decision in 2003 involving Walt Disney Co., CEO Michael Eisner, and the friend he briefly made president of the company, Michael Ovitz.
Disney shareholders sued the entertainment icon and its directors in 1997 over the payment of approximately $140 million in severance to Ovitz—who was ousted after little more than a year—calling the payment excessive and a waste of corporate assets. The Delaware Court of Chancery initially dismissed the suit, but on appeal the Delaware Supreme Court remanded it back to the lower court with hints that the plaintiffs should demand access to Disney’s books and records as a means of sharpening their complaint. They did, and in 2003 the Court of Chancery reversed itself and allowed the case to go forward. Although a final decision has yet to be handed down, the fact that the Chancery Court permitted the case to proceed stunned attorneys who had been expecting the business-judgment rule to prevail in the directors’ favor. In brief, the court said that the plaintiffs’ allegations, if true, implied that Disney’s directors had knowingly made material decisions without adequate information or deliberation and “simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss.” That was enough, it wrote, to warrant a trial.
Judge Jacobs calls the case the first to infuse content into the fiduciary duty of good faith and says it has enormous practical implications for board members. For starters, it would disqualify those who act in bad faith from the safe harbor provided by Section 102(b)(7) of Delaware corporate law. Under that safe harbor, shareholders may excuse directors from personal liability for damages that result from a breach of their legal duty of care; many companies routinely incorporate such excusals into their charters. The Disney outcome could also preclude directors who act in bad faith from being indemnified for litigation expenses and monetary judgments, as provided by Section 145 of Delaware corporate law. The lesson, says Judge Jacobs, is that directors should be fully informed when making significant decisions, including those involving executive compensation, and should ensure that their high level of care is properly documented.
3. Directors Confront a New World of Personal Liability
Thanks in large part to the business-judgment rule and other legal protections, corporate board members have seldom been held personally liable for their business decisions, no matter how much those might cost shareholders. That standard was called prominently into question early this year when former directors of Enron and WorldCom agreed to make out-of-pocket payments to settle lawsuits filed against them in connection with the accounting frauds that led the companies into bankruptcy court.
Twelve former WorldCom directors signed off on a $24.75 million settlement to help compensate investors who lost money in the corporation’s downfall, while 10 former Enron board members went along with a $13 million payment to resolve an investor lawsuit over that company’s implosion. The prior year, Enron’s former directors had agreed to pay at least another $1.5 million to settle a lawsuit filed by the U.S. Department of Labor alleging that the company had mismanaged employee retirement funds.
“This says to corporate directors that the liability environment, from a political perspective, has changed,” says former Chancellor William Allen, now director of the NYU Center for Law and Business.
While conceding the changed environment, former Delaware Chief Justice E. Norman Veasey calls the WorldCom and Enron cases “aberrations.” Douglas M. Hagerman, senior vice president, general counsel, and secretary of Rockwell Automation, concurs but says that the settlements may embolden other plaintiffs. In fact, he notes, some institutional plaintiffs now offer bonuses to their attorneys for obtaining out-of-pocket payments from officers and directors. “Couple this situation with an SEC enforcement staff that is itching to make an example out of derelict boards,” he warns, “and you do have a riskier situation.”
4. Caremark Confirms the Role of a Compliance System in Protecting Directors
The federal sentencing guidelines enacted by Congress in 1984 established, among other things, that corporations convicted of federal crimes could receive reduced fines if they maintained effective compliance programs to help them detect and prevent violations of the law. A 1996 Delaware Court of Chancery case involving Caremark Inc. extended that theory by suggesting that board members who don’t put such programs in place could find themselves personally liable in cases of corporate wrongdoing.
Caremark, a pharmaceutical-services company, was indicted along with some of its officers and employees in 1994 for violations of federal health-care laws. The company pleaded guilty to various offenses and agreed to $250 million in civil penalties, criminal fines, and restitution to private parties. Later, shareholders sued the company’s directors, alleging that they had breached their duties by allowing the criminal misconduct to occur. In 1996 the Delaware Court of Chancery, then led by Allen, found in favor of the directors, largely because they had established a compliance program. The court noted that failure to implement such a program could, in theory, leave directors liable for losses in similar circumstances. Judge Jacobs says the case was important because it spelled out for directors a duty to attempt, in good faith, to establish a legal-compliance system of the type contemplated by the federal sentencing guidelines.
5. The Rising Power of Shareholder Proposals
For years institutional shareholders were a generally agreeable lot who rarely challenged the officers or directors of the companies in which they invested. That began to change in the 1980s when the California Public Employees’ Retirement System (Calpers), which runs one of the world’s largest pension plans, started to question companies’ use of anti-takeover provisions. It feared they could be deployed to entrench management and compromise a company’s ability to realize full value in a takeover. Other institutional shareholders, including public and union pension funds, began joining such challenges in the 1990s. Today not only do institutional investors commonly file shareholder proposals over a wide array of corporate governance issues, it is also becoming increasingly common for those proposals to gain broad support from other stockholders. Professor Randall S. Thomas, director of the law and business program at Vanderbilt University, says that in the late 1990s it was rare to see a shareholder proposal get more than 30% or 40% of the investor vote. “Last year,” he says, “something on the order of 140 shareholders’ proposals passed with a majority of the votes cast, largely concentrated in the anti-takeover area, such as redeeming poison pills or eliminating staggered terms for directors.” Bottom line for the board: Be more certain than ever that you’re not rubber-stamping decisions that serve management at the expense of your shareholders.
6. Institutional Investors Become Formidable Class-Action Plaintiffs
Institutional investors haven’t limited their activism to shareholder proposals. Spurred in part by the passage of the Private Securities Litigation Reform Act of 1995, they’ve also become increasingly active in shareholder litigation. The reform act sought, in part, to shift control of shareholder lawsuits from plaintiffs’ attorneys to investors by mandating that the lead plaintiff would no longer be the shareholder who had filed suit first (often a small investor enlisted for that purpose by a plaintiffs’ attorney), but rather the shareholder who had lost the most money. Today public pension funds such as Calpers and the State of Wisconsin Investment Board actively watch for cases of corporate wrongdoing in which their participation in a lawsuit could produce increased returns or other benefits.
The result: Companies face more formidable plaintiffs. For example, the largest settlement on record in a class-action shareholder lawsuit was the $3.5 billion payout Cendant Corp. agreed to make in 1999 to resolve two lawsuits over accounting irregularities. The lead plaintiff in that case was a group of three public pension funds: Calpers, the New York State Common Retirement Fund, and the New York City Pension Funds.
The lesson for directors is clear. Institutional investors, once courted as long-term shareholders who would passively support management, can become activists willing to punish lax boards.
7. Mass Tort Product-Liability Litigation Becomes Common—And Costly
Mass tort litigation in product-liability cases—which bundles multiple complaints against a single defendant—has become a growing threat to U.S. businesses over the past decade. That is partly because plaintiffs’ attorneys have been able to exploit the Internet and mass advertising techniques to troll widely and economically for plaintiffs. “The implication of mass tort litigation on the scale it is occurring today is that the number of claims brought becomes astronomical and threatens the viability of companies,” says attorney Sheila Birnbaum, a partner at Skadden Arps Slate Meagher & Flom and head of the firm’s complex mass tort and insurance group. She points to numerous high-profile examples. “It started with the breast-implant cases against Dow Corning, then the diet-drug litigation against Wyeth, and now this huge litigation that’s developing against Merck in connection with the drug Vioxx,” she says. “It means that board members must give far greater scrutiny to issues they may not have focused on previously, because the implications of a product or device failing are so huge financially.”
Directors themselves may not be immune from litigation in product-liability cases. In 1999 Abbott Laboratories, in a settlement with the U.S. Food and Drug Administration over violations of FDA regulations, agreed to pay $100 million and stop making and selling many of its in vitro diagnostic tests until it corrected deficiencies. Shareholders later sued Abbott’s directors to recover the $100 million, arguing that the board had failed to discharge its oversight duties. The shareholders noted that over the course of six years the FDA had sent the company and its chairman warning letters identifying the violations and outlining potential consequences. In 2003 the U.S. Court of Appeals for the Seventh Circuit agreed to let the case, which has yet to be resolved, go forward. It remains in the U.S. District Court for the Northern District of Illinois, Eastern Division.
8. The Spitzer Model: State AGs Get Aggressive
For most of the 20th century—and certainly for most of the six decades following the 1934 legislation that created the Securities and Exchange Commission—violations of securities laws were prosecuted primarily at the federal level. But most states also have their own securities legislation, and in 2002 an aggressive New York state attorney general, Eliot Spitzer, reminded the world that they have teeth. Spitzer accused Merrill Lynch of misleading investors by touting Internet stocks that its own analysts had privately dismissed as dogs, and subsequently negotiated a $100 million settlement with the Wall Street giant. From there he moved on to high-profile and highly successful assaults on wrongdoing in the mutual fund and insurance brokerage industries. His example has helped spur other state attorneys general into action. In 2003 Oklahoma attorney general Drew Edmondson filed criminal charges against former WorldCom executives, alleging that the company’s accounting fraud had harmed Oklahoma investors. Edmondson has since dropped the charges to focus on serving as a witness against former WorldCom CFO Scott Sullivan in a federal case, but has promised to refile later. In April 2004 Massachusetts secretary of the commonwealth William Galvin wrung a $110 million settlement from Putnam Investments for mutual fund trading abuses. California state attorney general Bill Lockyer filed lawsuits last year against three mutual fund companies, quickly settling two of them. Colorado attorney general Ken Salazar sued the Invesco fund company and, along with the SEC, helped negotiate a $326 million settlement.
Says Sheila Birnbaum: “Eliot Spitzer started a movement that has been adopted by many other state attorneys general. It carries implications of enormous criminal and civil liabilities in areas where previously state governments had not been involved.” This is one more reason, she says, why corporate directors must get tough about ensuring that companies operate within the law.
9. Criminal Prosecution of High-Level Executives
Ten years ago it was common for allegations of corporate misdeeds to be resolved through civil, not criminal, proceedings. Shocked to attention by the rash of scandals, the Department of Justice, as well as state and local prosecutors, began launching criminal cases: against the Rigas family at Adelphia, against the now-defunct accounting firm Arthur Andersen, and against a whole row of top-echelon executives at Enron, WorldCom, HealthSouth, Tyco International, and other companies. Prosecutors likewise pursued criminal cases against financial-services corporations such as Merrill Lynch and Citigroup. Board vigilance is now part of a higher-stakes game.
10. United States v. O’Hagen: The Supreme Court Broadly Defines Insider Trading
Grand Metropolitan PLC, a British conglomerate, hired the Midwest law firm of Dorsey & Whitney in 1988 to represent it in a takeover bid for Pillsbury Co. Soon thereafter attorney James O’Hagen, who was employed by Dorsey & Whitney, began buying Pillsbury stock and options. When the takeover went through, O’Hagen’s holdings left him with a profit of $4.3 million—and an indictment on insider-trading charges. He was convicted and sentenced to 41 months in prison. The jury that put him away relied on the so-called theory of misappropriation, which had largely been devised by the courts. It held that the same laws that precluded corporate insiders from trading their company’s stock based on material nonpublic information could be extended to those using that information to trade another company’s stock. But in 1996 the Eighth U.S. Circuit Court of Appeals overturned O’Hagen’s conviction and pointedly rejected the misappropriation theory. Had that decision stood, it would have created an opportunity for people without a formal relationship with a target company to engage in insider trading. Instead, the government appealed to the U.S. Supreme Court, which, in a precedent-setting 1997 decision, upheld O’Hagen’s conviction and the misappropriation theory. The high-court ruling, says Vanderbilt’s Randall Thomas, “created a much wider net for the SEC to throw at a lot of subsequent insider-trading cases by endorsing misappropriation in a blanket way. The SEC now uses that in almost all of its insider-trading cases.” Because of the decision’s far-reaching effect, Thomas says, it has prompted many boards to adopt stronger insider-trading policies.
Milestone Mavens
Here’s who identified the biggest legal milestones for us:
William T. Allen
(Former Chancellor, Delaware Chancery Court)
Director and Nusbaum Professor of Law and Business,
New York University Center for Law and Business
Of Counsel, Wachtell Lipton Rosen & Katz
New York City
Sheila Birnbaum
Partner and Head, Complex Mass Tort and Insurance Group
Skadden Arps Slate Meagher & Flom
New York City
Douglas M. Hagerman
Senior Vice President, General Counsel, and Secretary
Rockwell Automation Inc.
Milwaukee
Jack B. Jacobs
Justice
Supreme Court of Delaware
Wilmington
Keith Johnson
Chief Legal Counsel
State of Wisconsin Investment Board
Madison
Harvey R. Miller
Vice Chairman
Greenhill & Co.
New York City
Robert Strauss
Partner
Akin Gump Strauss Hauer & Feld
Washington, D.C.
Randall S. Thomas
John S. Beasley II Professor of Law and Business;
Director, Law and Business Program;
Director, Vanderbilt-in-Venice Program
Vanderbilt University Law School
Nashville
Larry D. Thompson
(Former Deputy U.S. Attorney General)
Senior Vice President for Governmental Affairs and
General Counsel
Pepsico Inc.
Purchase, New York
E. Norman Veasey
(Former Chief Justice, Supreme Court of Delaware)
Partner
Weil Gotshal & Manges LLP
Wilmington, Delaware
