The Threat of Lawsuits is Down—But Stay Paranoid
from
July/August 2007
by Randy Myers
Three years ago, as repercussions from the Enron scandal shook boardrooms everywhere, many directors were convinced that their personal risk had never been higher. One called Sarbanes-Oxley and other new regulations “hunting licenses for trial lawyers.” Another lamented that “vulture lawyers” were driving up the cost of directors’ and officers’ insurance and frightening talented people away from board service.
Well, perhaps things weren’t so bad after all.
Last year the number of class-action securities-fraud filings plunged to its lowest level since Stanford University’s law school began tracking it in 1995: 110 cases in 2006, down from 178 in 2005 and 211 in 2004. Meanwhile, says a spokesperson at Advisen Ltd., a New York City firm that provides information on the insurance industry to insurance companies, insurance brokers, and other organizations, the price of D&O coverage has declined in each of the past three years (see the chart on page 19). Both factors clearly suggest that board service hasn’t become the personal-liability minefield directors once feared.
“The worst-case scenario never did develop,” says management consultant Shepherd G. Pryor IV, 60, managing director of Board Resources in Highland Park, Illinois, and a director of Taylor Capital Group Inc., a bank holding company in Rosemont, Illinois. “There haven’t been hundreds and hundreds of board members being indicted.” In fact, he allows, the combination of new governance regulations and hawklike oversight by the plaintiffs’ bar and securities regulators may have led to boardroom caution—including greater reliance on legal counsel—that has held off problems for directors.
Boards have had help from the courts too. The U.S. Supreme Court ruled in 2005 that plaintiffs in a securities class-action lawsuit must establish a causal link between their losses and fraud by the defendants. That ruling, in
Dura Pharmaceuticals Inc. v. Broudo
, reversed a lower-court decision in favor of Michael Broudo and a group of other investors who bought stock in Dura after the company released information about satisfactory development and testing of its Albuterol Spiros device, which delivers asthma medication. Several months later, Dura disclosed that the Food and Drug Administration would not approve the device because of reliability issues. Upon the release of the FDA decision, Broudo alleged that Dura and its officials had made misleading statements about the device in violation of Section 10(b) of the Securities Exchange Act. According to Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse, the Supreme Court ruling in favor of Dura “underscores the value of careful economic analysis in identifying the portions of a stock price decline that are caused by factors other than the fraud and that therefore cannot support the award of damages.” The decision, law analysts say, should reduce the volume of securities-fraud litigation by weeding out weaker claims.
Juries have also supported board members, most prominently in a 2005 verdict in the 295th Civil District Court of Harris County, Texas. Jurors there decided that the former directors of Pennzoil-Quaker State Co. did not, as alleged in a class-action lawsuit, violate their fiduciary duty to shareholders in 2002 by accepting a $22-per-share buyout offer from Shell Oil that some stock owners considered inadequate.
Of course, none of this means that directors should pay less attention to the real risks they face. And some situations carry more personal risk for them today than a few years ago, says attorney Jim Carroll, a litigation partner with Skadden Arps Slate Meagher & Flom in Boston. Board members at companies that file for bankruptcy protection, for example, have seen their responsibilities increase. Over the past few years, courts have held that directors assume fiduciary duties to creditors not just once a bankruptcy filing has been made—the traditional view—but even earlier, when it begins to look as though a bankruptcy filing is inevitable and the company enters the so-called zone of insolvency.
Directors can get into trouble when a company is in the zone of insolvency if, for example, they allow management to take action favoring the shareholders over the creditors.
Or say that management tries a clearly imprudent, high-cost, desperate long-shot strategy to keep from going bankrupt, and the move fails. When the company files for bankruptcy, the worth of most of the debt will have diminished even more than before the attempt, and creditors may then choose to come after the board members for breach of fiduciary duty.
Directors can also be held personally liable under certain circumstances when companies violate the Foreign Corrupt Practices Act by bribing foreign officials to obtain or retain business (see “Going Global: The Legal Perils Multiply” on page 54). New liability alerts have also been sounded for directors whose corporations have issued executive stock options. Delaware Chancery Court chancellor William B. Chandler III ruled in February that both backdating and “spring-loading” options (issuing them immediately before the release of good corporate news) are illegal. Jim Carroll warns that board members of companies found to have engaged in such actions—especially members of compensation committees—may come under increased scrutiny not just by plaintiffs’ attorneys but also by securities regulators.
So, yes, the overall risk climate for directors is a lot less dangerous than people once feared. But as a version of the old saying suggests, just because you’re paranoid doesn’t mean somebody isn’t watching you.
