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Blog Archive :: April 2014

Apr 24, 2014

Corporate Compliance Starts with Good Governance at the Top

This is the third post in this series of posts on corporate compliance issues for governing boards. We will wrap up our discussion on fiduciary duties, this time concentrating on the protections afforded to board members. Future posts in this series will expand on federal sentencing guidelines and best practices.

Protections Afforded to Board Members with Respect to Fiduciary Duties

In order to encourage independent persons to serve as board members, state law offers a number of legal protections to persons serving as board members.

1. The Business Judgment Rule

In evaluating a board member’s compliance with his or her fiduciary duties, courts generally follow the business judgment rule. Under the business judgment rule, courts do not inquire into the wisdom of actions taken by board members in the absence of self-interest, fraud, bad faith or abuse of discretion. The business judgment rule specifically applies to any situation board members make a decision which, in retrospect, was or is argued to be a bad one. If the board members are thereafter sued because of that decision, a court applying the business judgment rule will not second-guess the merits of the decision as long as the court finds all of the following to be true:
  • The board members made a business decision (the rule does not apply to acts of board members which do not constitute business decisions);
  • The board members were disinterested (that is, they are not “on both sides of the transaction” and will not derive any personal benefit from the decision);
  • The board members exercised “due care” (as noted above, this means acting like an ordinarily prudent person would act);
  • The board members acted in good faith; and
  • The board members did not abuse their discretion.
If one or more of these factors is not satisfied, the court will interpose its own judgment to determine whether or not the transaction in question was in the best interests of the organization.

It is important for board members to note that having a personal or economic interest in the matter decided rebuts the business judgment rule for those board members having a personal or economic interest, unless those interested board members can show that the material facts of their interest were disclosed or otherwise known to other board members and at least a majority of the non-interested board members.

The business judgment rule will also be rebutted for non-interested board members who approve the matter unless they can show that, despite the personal or economic interest of the interested board members, the non-interested board members believed the matter to be in or not opposed to the best interests of the organization or that the transaction was fair to the organization from a substantive point of view.

When the business judgment rule is rebutted, courts generally require board members to prove fairness not only from a financial viewpoint, but also from a procedural or “fair dealing” viewpoint.

Officers generally are also protected by a similar business judgment rule. However, the business judgment rule does not protect officers in derivative matters or matters when officers’ actions are in violation of their authority.

Nevertheless, although the business judgment rule protects board members from mistakes in judgment, the rule does not protect board members who misleadingly hide or fail to disclose such mistakes.  Shareholders are entitled to judge board members’ mistakes in determining whether to vote for or against the election of such board members. Manipulating financial statements not to reflect such mistakes or intentionally hiding mistakes from shareholders or the investing public may result in liability to board members under federal and state securities, federal and state tax laws, state corporation law, as well as under theories of common law fraud.

2. Right of Reliance on Others

Board members are permitted to rely reasonably upon information presented by officers, employees, board committees and independent professional advisors in making their decisions.

Source of Information Presented to the Board member: Reliance is Appropriate if:
Other board members, officers or employees of the organization The board or committee reasonably believes such persons are reliable and competent in the matters prepared or presented.
Legal counsel, public accountants or other experts The board or committee reasonably believes that the matters prepared or presented are within the person’s professional or other competence.
A committee of the board on which the board member in question does not serve The committee has been duly established in accordance with the organization’s governing documents, is acting within its designated authority, and is reasonably believed by board members to merit confidence.

Under Ohio law, a board member, officer, employee or other agent of an organization who is successful on the merits or otherwise in defense of any action, suit, or proceeding in which he or she is named by reason of being a board member, officer, employee or other agent is entitled to be indemnified against expenses, including attorney fees actually and reasonably incurred by him in connection with the action, suit or proceeding.

3. Contractual Indemnification

Ohio law permits corporations and certain other organizations to indemnify or agree to indemnify board members, officers, employees and agents in advance of a decision on the merits and even if he is she is not successful on the merits, provided that the person:
  • Acted in good faith;
  • In a manner the person reasonably believed to be in or not opposed to the best interests of the organization; and
  • With respect to any criminal action or proceeding, had no reasonable cause to believe the person's conduct was unlawful.
The organization may pay or reimburse the indemnified person for all expenses (including attorney fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding.

In order for there to be protection, there must be a determination that indemnification is proper by:
  • A majority of board members who are not parties to such action, suit or proceeding; or
  • A committee of such disinterested board members; or
  • If there are no such board members, or if the board members so direct, by independent legal counsel; or
  • The shareholders; or
  • A court of competent jurisdiction.
As discussed above, indemnification is mandated by statute if the indemnified person is successful on the merits or otherwise in defense of any such action, suit or proceeding.

In a derivative or other action by or in the right of the organization, only expenses are indemnified unless the indemnified person is successful in defense of the claim. No indemnification of even expenses is available if the board member is adjudged to be liable to the organization unless the presiding court determines the board member is entitled to indemnification.

Many state courts have held that indemnification is not available for intentional misconduct and federal courts have held that indemnification is not available for securities law violations for reasons of public policy.

4. D&O Insurance

One value of Directors and Officers liability insurance (D&O) is that Ohio and most other states’ laws permit broader coverage under D&O insurance than under statutory indemnification. Another value of D&O insurance is that it is available even if the organization is insolvent and even after a change in control.

D&O insurance is typically a claims-made policy that pays losses or reimburses the organization for its payment of losses incurred by a covered person for claims of wrongful acts made during the policy period. The policies often insure against breaches of duty, neglect, errors, misstatements, misleading statements, omissions or acts, whether in a personal action or a derivative action. The policies sometimes include intentional wrongdoing, usually in the absence of dishonest or criminal conduct.

These policies often contain a securities law exclusion excluding coverage claims for wrongful acts in the purchase of sale or the organization’s securities. For this reason, board members of publicly-traded organizations will generally need to have a securities law endorsement expanding coverage to include claims of such wrongful acts.

These policies also exclude coverage claims that are not reported to the insurer in a timely fashion as well as claims alleging:
  • Death, bodily injury, sickness, disease or tangible property damage or destruction;
  • Environmental discharge or damage;
  • Libel or slander;
  • Disgorgement of profits under section 16(b) of the Exchange Act;
  • Employee benefit plan liability;
  • Illegal remuneration (unless approved by shareholders);
  • Suits by other insureds; and
  • Dishonest or criminal acts.
Steps to Enhance Board Members’ Protections

Coupling the basic tenet that board members “direct” management and must therefore delegate with the conditions to a board member’s right of reliance on others offers a framework for determining a board member’s duties. Because a board directs rather than manages and because management manages under that direction, a board must determine reliability and competence of management for each matter that the board delegates to them.

The best way to determine reliability and competence is to ask questions.  Accordingly, the purpose of the questions must be to test management’s reliability and competence.

The same questions should be asked separately of different persons, trying to include where appropriate someone independent of management. Possible persons independent of management include the person serving the internal auditor function, representatives of the external auditor, outside legal counsel, and outside experts with experience in the matters under consideration.

The consistency of the different answers should be compared. The answers among different constituencies will unlikely be the same. For example, management is more likely to view certain business issues more positively than the external auditor or chief legal officer.  On the other hand, the external auditor and chief legal officer are more likely to view risks of liability as more material than management. And often a chief financial officer views a matter from a different perspective than the chief executive or chief operating officer. Accordingly, answers will differ, but there should be consistency.

The skill is to learn when to stop asking questions. Nothing is more bothersome to management than irrelevant, unnecessary questions. As a general rule, board members should stop asking questions and accept the answers when those answers are consistent. On the other hand, board members should delve deeper when the answers to the questions are inconsistent.

Board members and management should expect there will be some tension between them during this process. Management needs to understand that board members must ask questions to determine whether management is reliable and competent for the matters delegated to them. The board should understand that management will fear “being micro-managed” or “not being trusted.”  For this reason, the chair or lead board member of the board should from time to time remind management that board members are required to ask such questions to fulfill their duties and that management should not necessarily view this as an adversarial process.

An additional way to relieve this tension is for the board to have regular separate executive sessions with different members of management so that it becomes part of the routine operation of the board.  A board should consider meeting regularly with the CEO, CFO, chief legal officer, internal auditor and representatives of the external auditor.

This is the third and final post on fiduciary duties in this corporate compliance series. The next post will cover discuss sentencing guidelines: what can be learned?


Posted by J. Beavers in  Fiduciary Duties   |  Permalink


Apr 10, 2014

Corporate Compliance Starts with Good Governance at the Top

This is the second post in this series of blogs on corporate compliance issues for governing boards. We will continue to discuss fiduciary duties, this time concentrating on some special areas of concern for board members under their fiduciary duties. Future posts in this series will expand on fiduciary duties, federal sentencing guidelines and best practices.

Some Special Areas of Concern for Board Members under Their Fiduciary Duties

A board member should be particularly concerned that the organization has established and implemented programs designed to address the following:

1. Managing Risks of the Enterprise

Non-ERISA Plan Assets

Managing risks of the enterprise is a developing area of law for both the board and its management. The duties for managing risks for fiduciaries of employee benefit plans subject to ERISA with respect to plan assets are different than those for board members and officers with respect to other assets.

With respect to assets other than those that are part of an employee benefit plan subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), the duties of boards and officers are their corporate law duties of care and loyalty (i.e., to act with the care that an ordinarily prudent person in a like position would use under similar circumstances and in a manner believed to be in the best interests of the organization; or, with respect to board members, not opposed to the best interests of the organization). A developing area of the duty of care is a duty to minimize the risk of large losses to the extent that an ordinarily prudent person in a like position would do so under similar circumstances for the best interests of the organization.

Because boards are not expected to manage assets, their duty with respect to management of risks is one of oversight. Boards, or an appropriate committee of the board under its direction, should periodically review with appropriate officers and, in some cases, the internal and external auditor:

  • The systems of internal financial control and the monitoring of their adequacy;
  • The systems for protecting the organization’s assets, including the adequacy of insurance as well as protecting intellectual property and safeguarding confidential corporate information; and
  • The systems for assuring that transactions are executed in accordance with management's general or specific authorization.

The NYSE and NASDAQ have delegated this duty of oversight to the audit committee or, if it does not do so, all of the independent board members. The Sarbanes-Oxley Act (SOX) requires management of public reporting companies, with the participation of their CEOs and CFOs, to annually evaluate the portion of these systems related to financial reporting as part of management’s report on internal controls over financial reporting.

ERISA Plan Assets

The duties are greater with respect to assets of an employee benefit plan subject to ERISA, a fiduciary of the plan is to act solely in the interest of the participants and beneficiaries and—

(A) For the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan;

(B) With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;

(C) By diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so; and

(D) In accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with ERISA.

A fiduciary’s duties are different from the corporate law duty of care and loyalty in several significant ways. The duty of care is also greater in that a fiduciary is to act with the care that a prudent man acting in a like capacity and familiar with such matters would use, which is a higher standard than the care that an ordinarily prudent person in a like position would use.  More significantly, the duty of loyalty is not to the organization, but is “solely” for the interests of the participants and beneficiaries for the “exclusive” purpose of providing benefits and defraying reasonable expenses of administering the plan.  Most significantly, a fiduciary has an express duty to diversity the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

A person is a fiduciary if he or she:

  • Exercises any discretionary authority or discretionary control respecting management of such plan or
  • Exercises any authority or control respecting management or disposition of its assets
  • Renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or
  • Has any discretionary authority or discretionary responsibility in the administration of such plan

Boards are fiduciaries if they have or exercise the authority or control of a fiduciary described above.  Department of Labor regulations provide that a board or committee of the board is a fiduciary responsible for the selection and retention of plan fiduciaries, such as the trustee or plan administrator.
Boards and officers should confirm whether or not they are named fiduciaries of any ERISA employee benefit plan.  A named fiduciary has both statutory as well as contractual responsibilities and, accordingly, corresponding liabilities.  Although a named fiduciary has a right of reliance on others, that right of reliance is only on others who are also named fiduciaries and only to the extent the plan documents permit such delegation of authority or responsibility.

2. Quality of Disclosure

Do the organization's disclosure documents (quarterly and annual reports to shareholders, proxy statements, prospectuses, press releases, web pages and other key communications to shareholders and the investing public) fairly present material information?  A board member's primary responsibility in the disclosure process is to be satisfied that corporate procedures are reasonably designed to produce accurate and appropriate public disclosures.  Management has the primary responsibility for implementing these processes, subject to board members' oversight and periodic review of the steps taken by management.

3. Compliance with Law

Does the organization have appropriate policies designed to result in compliance with applicable laws and regulations?  Does the board receive reasonable assurances that employees of the organization are informed of corporate policies directed at compliance with applicable laws, including antidiscrimination and employment laws; environmental and health and safety laws; antitrust laws; and securities laws, particularly those prohibiting insider trading? 

The organization should have appropriate procedures for monitoring compliance with such laws throughout the organization. All persons involved in the compliance process should have direct access to the general counsel or other compliance officer so that sensitive compliance situations may be raised for prompt consideration. Board members do not administer legal compliance programs, but should review their functioning periodically and endeavor to be reasonably satisfied that appropriate programs are in place.

Most large, publicly owned organizations have adopted codes of business conduct expressing principles of business ethics, legal compliance and other matters relating to business conduct. Subjects commonly addressed by such codes are legal compliance (antitrust laws and policies, Foreign Corrupt Practices Act of 1977 and insider trading, to name a few), conflicts of interest, corporate opportunities, gifts from business associates, misuse of confidential information and political contributions.

A program of legal compliance that is well-conceived and properly implemented can significantly reduce the incidence of violations of laws and corporate policy. It may also reduce or eliminate civil lawsuits, penalties or prosecution against the organization for those violations of law that occur in spite of such a program. Since the enactment of the United States Sentencing Commission's sentencing guidelines, organizations have been given further reason to review and reassess their compliance policies and procedures. These guidelines greatly increase the penalties for businesses found guilty of criminal violations, but provide significant fine reductions for convicted organizations that maintain appropriate programs to prevent and detect violations of law.

4. Approval of Commitments

Is there a functioning and effective system in place for approval of commitments of the organization's financial and commercial resources?

Although board approval of all or even most corporate commitments is not necessary, the board should be satisfied that a reasonable approval system exists and should have a clear understanding with management, which may be embodied in a formal policy, as to which major commitments require board approval.

5. Adequacy of Internal Controls

Does the organization maintain appropriate systems of internal financial control, and is there a functioning and appropriate system for monitoring their adequacy? Periodic review of the functioning of these systems is appropriate.

Protection of Assets

Does the board receive periodic reports describing the organization's program for the protection of its assets? In addition to insurance arrangements, such a program should include procedures for protecting intellectual property and safeguarding confidential corporate information.

6. Counseling of Board members

Does the organization provide board members competent legal advice regarding the organization's affairs and the conduct of its board members?  In addition to the organization's general counsel or regular outside counsel, there may be occasions when an additional outside legal advisor should be specially retained by the board or a committee in connection with a particular matter.

7. Disagreements

If, after a thorough discussion, a board member disagrees with any significant action proposed to be taken by the board, the board member may vote against the proposal and request that the dissent be recorded in the meeting's minutes.  Except in unusual circumstances, taking such a position should not cause a board member to consider resigning.  However, if a board member believes that information being disclosed by the organization is inadequate, incomplete or incorrect, or that management is not dealing with the board members, the shareholders or the public in good faith, the board member should first encourage that corrective action be taken.  If that request is not satisfied or the problem continues, the board member should encourage the board to replace management and, if such a change does not occur, the board member should resign.

The next post in this series will continue on the topic of fiduciary duties with focus on the protections afforded to board members with respect to fiduciary duties.


Posted by J. Beavers in  Fiduciary Duties   |  Permalink




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