United States: Protecting Corporate Directors In The Post Sarbanes-Oxley World

The Wall Street Journal recently reported that 19 of 20 candidates approached by a search firm refused to serve as corporate directors. This is not surprising given well-publicized assaults by Congress, shareholders, and others on corporate directors, and the passage of the Sarbanes-Oxley Act, Pub. L. No. 107-204, 116 Stat. 745 (2002), which increased directors’ duties and exposure to liability. In this climate, general counsels and their legal staff can expect questions from current and potential directors about the risks of serving. This article briefly examines Texas law on director liability and Sarbanes-Oxley and concludes that honest, conscientious directors still have substantial protections from personal liability.¹

Before the bank and savings and loan failures in the Southwest in the early 1980s, serving as a corporate director was prestigious and often not very demanding. Many outside directors viewed their only responsibilities to be hiring a competent CEO and monitoring the corporation’s earnings. They usually were not qualified to analyze complex loans and business transactions and did not believe they were required to. Suits against directors were not a common occurrence.

The world of bank directors changed dramatically soon after the Penn Square Bank of Oklahoma City failed in 1982. As more banks and savings and loans collapsed, the federal deposit insurance agencies faced huge losses. They sought to recover those losses from the directors of failed banks and thrifts. The agencies, suing as the bank’s insurer and receiver, typically alleged that directors were negligent in failing to adequately monitor the underwriting of loans that had gone bad and to ensure compliance with federal banking regulations. These cases tended to settle because of the huge damages alleged and the relative ease of proving some act of negligence such as failing to obtain a more current appraisal or additional collateral. Most directors were protected by Directors and Officers Liability ("D&O") insurance but some paid large sums from their personal funds to settle with the Government. The position of corporate director suddenly was not so attractive.

Concern arose that the federal government’s aggressive litigation against bank directors for "negligence by hindsight" was scaring off the very successful business persons who should be serving on corporate boards; only persons who were judgment proof could safely serve. FDIC v. Brown, 812 F. Supp. 722, 723 (S.D. Tex. 1992). To encourage directors to serve, states passed "director shield" laws, e.g., TEX. REV. CIV. STAT. ANN. art. 1302-7.06(B) (Vernon 1997), and amended their corporation laws to give companies broad powers to indemnify their directors and purchase D&O insurance. TEX. BUS. CORP. ACT ANN. art. 2.02-1(B) (Vernon Supp. 2002).²

In addition, federal courts in Texas, addressing the Government’s ordinary negligence claims that sought to make directors "guarantors" of a bank’s loan portfolio, concluded that under Texas law disinterested directors were liable only for gross negligence in the performance of their duties. FDIC v. Schreiner, 892 F. Supp. 869, 881-82 (W.D. Tex. 1995); FDIC v. Benson, 867 F. Supp. 512, 521-22 (S.D. Tex. 1994); FDIC v. Harrington, 844 F. Supp. 300, 305 (N.D. Tex. 1994); RTC v. Norris, 830 F. Supp. 351, 357 (S.D. Tex. 1993); FDIC v. Brown, 812 F. Supp. 722, 725-26 (S.D. Tex. 1992). These courts defined gross negligence as an "entire want of care," Brown, 812 F. Supp. at 725, or "a complete abdication of the directors’ responsibilities." Norris, 830 F. Supp. at 357.³

A leading case on the duties of corporate directors under Texas law is Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707 (5th Cir. 1984). The court ruled that directors are fiduciaries who owe their corporation the duties of obedience, loyalty, and due care. Id. at 719. "The duty of obedience requires a director to avoid committing ultra vires acts, i.e., acts beyond the scope of the powers of a corporation . . . ." Id. "The duty of loyalty dictates that a director must act in good faith and must not allow his personal interests to prevail over the interests of the corporation." Id. "The duty of care requires a director to be diligent and prudent in managing the corporation’s affairs." Id. at 720. Gearhart also held that directors are not liable for mistakes of business judgment if they act "in good faith and without corrupt motive." Id. at 721.

Gearhart apparently was read by the federal banking agencies to permit recovery against directors for ordinary negligence. That misconception was soon put to rest by the decisions cited above. Relying on Gearhart, the courts held that the business judgment rule protects a director from liability unless his acts are fraudulent, ultra vires, grossly negligent, or a complete abdication of the director’s responsibility. Schreiner, 892 F. Supp. at 882; Brown, 812 F. Supp. at 725-26. In Brown, Judge Lake explained the rationale for the business judgment rule:

812 F. Supp at 723. These courts also ruled that the business judgment rule is not just a defense to an action for breach of the duty of care but a substantive rule of law that a plaintiff must over-come with pleadings and proof. Id. at 724; Benson, 867 F. Supp. at 521-22.

These decisions raised the bar for suits against directors. Gearhart and its progeny make it difficult for Government agencies, bankruptcy trustees, shareholders, or others suing on behalf of the corporation to impose liability on a diligent director who acts in the best interests of his company. They do not protect, of course, a director who engages in fraud or self-dealing or completely abdicates his responsibility as a director, for example, by rarely attending board or committee meetings.

As D&O insurance carriers recovered from the bank failure cases, coverage became cheaper and available with higher limits throughout the 1990s. Directors became more willing to serve, because they were protected from liability except for gross negligence or intentional misconduct, indemnified against most claims by the corporation, protected by D&O insurance, and in many cases well compensated.

The pendulum has swung again, and a corporate directorship is considerably less appealing than it was a year ago. Directors have been pilloried in the press and Sarbanes-Oxley has expanded their duties and established severe criminal penalties for violation of some of its provisions. Pub. L. No. 107-204, 116 Stat. 745 (2002). In addition, D&O premiums have increased substantially. AIG, a large D&O insurer, announced in February that it had increased its loss reserve by more than $1 billion, largely for D&O claims.

The details of Sarbanes-Oxley are beyond the scope of this article. Some of its provisions have not yet been implemented by SEC regulations and many do not apply to directors. Clearly, however, the Act has to some extent federalized the duties of officers and directors that used to be controlled by state law, has shifted power from the CEO to the board of directors, and has put directors on notice that they are expected to play a major role in guiding their company. Sarbanes-Oxley has not changed the state common law duties of directors described above, but it has added specific federal law duties with which directors must comply. The following are just a few highlights of the Act that apply to directors:

• Sarbanes-Oxley focuses on financial disclosure by public companies. It requires more disclosure, and some information must be disclosed sooner. Id. at § 403. CEOs and CFOs must certify the accuracy of the company’s financial reports filed with the SEC. Id. at §§ 302, 906.
• The duties of the audit committee are substantially expanded. The independent accountants must report directly to the audit committee and must disclose to the committee disagreements with management on critical accounting policies and issues. Id. at § 204. The audit committee must consist of only independent board members, and the company must disclose whether the committee has one member who is a "financial expert." Id. at §§ 301, 407. The "financial expert" must have acquired his expertise working at a public company as an auditor or principal accounting or financial officer, as a public accountant, or through other relevant experience. Id. at § 407.
• Most personal loans to executives are banned. Id. at § 402.
• Directors are required to disclose changes in their ownership of the company’s securities within two days. Id. at § 403.

In the post Sarbanes-Oxley world, how can a company protect its directors from liability? To begin with, the company must insure that directors have a solid understanding of their legal duties under state law and under Sarbanes-Oxley and comply with them. If a director is sued, his conduct could be scrutinized by a judge or jury to determine if he adequately discharged his fiduciary duties. Company counsel should be prepared to provide directors with advice on these duties. Counsel’s advice should include, at a minimum, the following:

• Always act in the best interests of the company.
• Hire an honest, competent CEO and monitor his performance.
• Attend board and committee meetings and carefully review the company’s financial reports. Ask questions at board meetings.
• Hire an experienced and reputable accounting firm and meet with representatives of the firm periodically without management present. Ensure that management is cooperating with the accountants.
• Review board minutes to be sure that the director’s votes, especially dissenting votes, and those of other board members are recorded.
• Meet occasionally with the CFO without the CEO present and ask him about the company’s financial condition and performance.
• Ensure that the corporation has an ethics policy and that it is followed. Consider assigning the general counsel to monitor and enforce compliance with the ethics policy.
• Ensure that the company has a strong audit committee and audit committee chairman.

In addition, directors will want to ensure that the company indemnifies them to the maximum extent permitted by law. If a director is sued, the company probably will pay his legal fees and the cost of any judgment or settlement if the director acted in good faith. If the corporation goes bankrupt, however, the corporate indemnity may be worthless.

The last line of defense is the D&O policy. Counsel should analyze the company’s D&O insurance so he can discuss it with directors. If the limits are not adequate for the risks involved, the company may need to obtain additional coverage. Most D&O insurance is written by a few companies and the policy terms are similar. Be sure, however, that the policy provides adequate coverage and has no unusual exclusions.

The risks of serving as a corporate director are greater than they were a year ago but the honest, diligent director still has substantial protection from personal liability.