Twice in the last week, directors revealed they will have to dig deeply into their own pockets to settle class action litigation. Ten former directors of WorldCom will contribute $18 million of their own money as part of a $54 million settlement with shareholders. And ten former Enron directors are paying $13 million of their own funds in connection with a $168 million settlement of shareholder claims.

Until now, outside directors rarely, if ever, contributed personally to settlements of class-action litigation. Settlements were funded by companies (pursuant to indemnification obligations) and directors’ D&O insurers.

Do WorldCom and Enron signal a new trend? In some ways, both settlements can be explained away by the extreme and unusual nature of the cases.

The WorldCom case arises out of what many have called the largest corporate fraud, and the largest corporate bankruptcy, in history. The litigation already has produced gargantuan settlements by other defendants -- Citigroup, for example, settled the claims against it for a whopping $2.65 billion. Worse, pretrial rulings have already established that WorldCom made misleading statements in a bond prospectus signed by the directors. And the directors faced difficult accusations regarding their approval of a $408 million loan of corporate funds to Bernard Ebbers (WorldCom’s CEO).

The Enron debacle also has achieved new heights of notoriety and shareholder losses. More than thirty individuals have either been convicted or pleaded guilty for their roles in Enron's demise. Many of the accused outside directors profited handsomely over the years from sales of Enron stock, and some were seen as friends of tarnished CEO Kenneth Lay.

The WorldCom and Enron cases have other things in common. Both achieved unprecedented negative worldwide press coverage. And the lead plaintiffs in both cases are public employee pension funds. Leaders of these pension funds (some of whom are elected officials) have been quoted as saying the settlements were meant to send a message to directors and raise the standard for acceptable corporate management.

Press reports indicate that the settling WorldCom directors are paying approximately 20 percent of their net worth (excluding homes, retirement funds, and certain other assets) as their share of the settlement (although some directors apparently are paying higher percentages than others). The payments by the Enron directors apparently were determined, not based on net worth, but as a percentage of pre-tax profits earned by them on sales of Enron stock.

While the WorldCom and Enron cases are, in many ways, extreme, directors of other companies embroiled in shareholder litigation should now expect to receive demands for personal contributions towards settlements. Plaintiffs' lawyers will be quick to say these other cases are "like WorldCom" or "like Enron," and so are deserving of personal settlement payments by individual directors. WorldCom and Enron will both serve as precedents in future settlement negotiations.

Can directors do anything do avoid the risk of losing personal assets? Here are some things directors can do now to minimize their exposure:

  1. Deeper due diligence before accepting a board position. Some risks just aren't worth taking. Before accepting a board seat, directors should determine whether a company has: (1) A charter provision eliminating or limiting directors' liability; (2) A stable earnings history and solid balance sheet; (3) A majority of truly independent and well-qualified outside directors; (4) Experienced outside auditors; (5) An internal audit staff; (6) An experienced and qualified general counsel; (7) A code of conduct that complies with NYSE and NASDAQ guidelines; and (7) An experienced and knowledgeable investor relations function.

  2. Increased vigilance Over Compliance. Directors used to be business counselors; now they are more like compliance officers. Directors need to pay heightened attention to the monitoring and compliance aspects of their position. This means: (1) More board meetings and committee meetings; (2) Personal meetings with key personnel; (3) In-depth financial reports and analyses; (4) Periodic meetings with the General Counsel and external legal advisors; and (5) Implementation of the internal controls, whistleblowers, and audit committee requirements of the Sarbanes-Oxley Act of 2002.

  3. Careful scrutiny of executive compensation and related party transactions. Executive compensation, financial transactions involving employees, and conflicts of interest all invite extra scrutiny. Directors should make sure: their company's compensation committee is comprised entirely of truly independent directors and is advised by a knowledgeable compensation consultant; their company has robust conflicts of interest and insider trading restrictions; and has strict procedures in place for reviewing and approving any financial transactions with officers or directors.

  4. Indemnification agreements and full D&O insurance protection. Directors should have written indemnification agreements entitling them to the full protection permitted by law. They should also have an updated D&O insurance coverage program designed by advisors with real experience and knowledge regarding the "claims" side of the insurance business. They should also secure supplemental "Side A" coverage that protects outside directors even when a company is financially unable to fund its indemnification obligations, when traditional D&O insurance has been depleted, or when a company's primary insurer denies coverage, rescinds the primary policy, or fails or refuses to respond to a claim.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved