By Kenneth Kohler, James Junewicz and Michael Hermsen

Originally published January 31, 2005

Earlier this month, outside directors of WorldCom and Enron agreed to use their personal funds to settle shareholder litigation arising from the collapse of their companies. In the WorldCom case, ten former directors agreed to supplement $36 million supplied by their D&O insurance by paying $18 million of their own money, or about 20% of their aggregate personal net worth (excluding certain assets such as their primary residences and retirement accounts) even though they collectively lost about $250 million of value of their own stock investments in WorldCom. Ten former directors of Enron agreed to a settlement requiring them to hand over $13 million of their own personal funds.

These settlements may signal a trend instigated by large institutional shareholders in favor of the increasing use of personal funds to settle lawsuits against outside directors. The lead plaintiff in the WorldCom case, the New York State Common Retirement Fund, insisted that the former directors use their personal funds to pay a significant portion of the settlement. Alan Hevesi, New York’s state controller and a trustee of the retirement fund, stated, "I felt personally that this [the WorldCom settlement] would be unfair and not a deterrent for future failures on the part of directors if they weren’t held personally liable." More generally, some institutional shareholders are reportedly offering plaintiffs’ lawyers additional fees if settlements include directors’ personal funds. Press accounts indicate that many directors of U.S. public companies are wondering whether serving on boards is worth the risk in view of the readiness of these powerful institutions to use the threat of personal liability as an in terrorem corporate governance device.

In response to these concerns, which we do not consider to be unrealistic, we would state that the risk of personal loss exemplified by the Enron and WorldCom settlements should not automatically cause qualified and committed individuals to refuse to serve on corporate boards. These are, after all, negotiated settlements arising from egregious factual situations and are not court decisions that increase the liability of directors or reduce the protection provided by the business judgment rule when its requirements are correctly observed. However, we strongly believe that these settlements emphasize the critical importance for directors of being very careful in accepting board positions and of being acutely aware of—and willing to perform vigorously—their duties as board members. The basic lesson of these cases is simple: directors must take an active personal interest in what is going on, must look for "red flags," and must be willing to ask tough questions of management and follow up with strong action if required. Directors politely deferring to management may face the wrath of institutional shareholders insisting that they use their personal funds to make settlement payments and willing to pay lawyers additional fees to ensure that they do so.

Here are some questions that prospective and current board members should think about:

  1. Why have I been asked to join the board? Is it because of my industry expertise or business acumen, or is it because I have credentials that will be impressive to investors and the world at large? Does management truly want my input on the future path the company will take, or does management want me to be "supportive" of its initiatives? How often are board discussions characterized by vigorous debate? Does management truly value and encourage constructive debate and criticism, or is the prevailing mentality that the primary role of the board is to monitor the performance of the CEO and to compensate him or her appropriately? What do I know about the members of senior management? Would I be comfortable in trusting them with matters of personal importance to me and my family? Do I have business, family or social connections with management that could call my independence into question?
  2. What do current directors say about the "culture" of the company? Are meetings short and characterized by little discussion and debate? How interested do the other directors seem to be in carefully performing their duties? Has the company considered the selection of a "lead director" to coordinate the work of board members? Are directors given an adequate education about the business of the company and the industry in which it operates?
  3. Are the outside directors encouraged to meet privately and to have their own counsel if they desire? How frequent are executive sessions of the board?
  4. Does the company take full advantage of the protections allowed to directors under state law, including exculpatory charter provisions, charter and bylaw indemnification provisions and indemnification agreements? Is the indemnification mandatory or is further action required to activate the indemnification provisions? Similarly, does the company advance indemnification-related expenses on a mandatory, rather than permissive, basis? Are fees incurred to enforce indemnification rights covered?
  5. Is the company’s D&O insurance adequate to protect me? Are the policy limits adequate in the judgment of a reputable insurance consultant? Have I received and/or reviewed a copy of the application and the policy? Have I had the terms of the policy reviewed by a lawyer with experience with respect to D&O coverage issues? Other important questions include whether there are pending claims against the policy that effectively reduce available coverage and whether management has confirmed to the board the accuracy of the representations made in securing the coverage. Directors should consider the availability of so-called "Side A coverage," which provides a separate source of insurance proceeds for officers and directors that cannot be diminished by claims against the company. Some Side A policies provide that the policy is not cancelable, even in the case of significant developments like earnings restatements. More generally, directors should challenge their D&O insurance carriers to develop insurance products that immunize their personal assets from attack.
  6. Does the company have an experienced internal audit staff and a strong outside auditor? What do the outside auditors say about the willingness of management to follow its advice and to adhere to the best accounting practices? Does management insist on compliance with "best practices" in the areas of financial reporting and controls?
  7. Compensation issues are especially important. Does the company have a compensation philosophy discussed and approved by the full board? Does the company have a strong and independent compensation committee and use knowledgeable compensation consultants? What procedures are followed in approving transactions with management?
  8. Does the general counsel attend board meetings and is he or she available to answer questions? Is the company represented by counsel that is experienced and knowledgeable about the company? How important is the company to the law firm’s overall financial well-being?
  9. Will I have free access to key members of management or will all of my information about the company essentially come from the CEO or CFO?
  10. Finally, am I willing to be unpopular or "controversial" if being so is necessary to do what is right for shareholders? Am I willing to resign from the board if my efforts are unsuccessful?

In closing, all current and prospective board members should keep in mind the following passage from the report of the WorldCom Special Investigative Committee and resolve that its words can never be applied to them:

The Board and the Audit Committee did not function in a way that made it likely that red flags would come to their attention…. They must create the environment and the opportunities that give them the best chance of learning of issues requiring their attention. The WorldCom Board and the Audit and Compensation Committees were distant and detached from the workings of the Company. [The CEO] controlled the Board’s agenda, its discussions and its decisions. The Board did not function as a check on [the CEO] and he created a corporate environment in which the pressure to meet the numbers was high, the departments that served as controls within the Company were weak, and the word of senior management was final and not to be challenged.

Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc. 282-3 (March 31, 2003).

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Mayer Brown is a combination of two limited liability partnerships: one named Mayer Brown LLP, established in Illinois, USA; and one named Mayer Brown International LLP, incorporated in England.