The corollary to “the more thingschange, the more they stay thesame” is that no one can accuratelypredict what is going tochange next. Economic forecastsrange from dire to optimistic, andthe march of unexpected eventscontinues without end in sight.Seemingly solid financial institutionshave been shaken byunforeseen market conditions;merger and acquisition transactionsthat appeared certain havefallen apart; and everyone frompresidents to Fed chairs are comingunder scrutiny and facingcriticism. Harsh consequencesfor behavior that once appearedforgivable is now the rule, not theexception.
In this current period ofvolatility, directors may be surprisedat how quickly a company’sfortunes can change. Theymay find themselves in a difficultsituation through no fault of theirown or their board’s. It is of paramountimportance in these circumstancesfor directors toremember that even in the mostuncertain of times, the fundamentalsof directorship continueto apply: directors must responsiblyoversee company affairs. Thebusiness-judgment rule remainsthe standard for judicial review oftheir ordinary-course businessdecisions.
Although well known to mostdirectors, like the Boy Scoutmotto, it bears repeating: In thebroadest sense, it is the responsibilityof directors to oversee theaffairs of a company and it ismanagement’s job to run the day-to-day operations. In times ofmarket uncertainty, there aregenerally three main areas onwhich directors should focustheir attention: the state of thecompany’s business, the qualityand depth of the company’s management(including successionplanning), and the company’sliquidity.
This Year’s Model
Paying careful attention to theoverall state of the company’sbusiness is central to a director’sresponsibilities. Directors should,in response to changing economicconditions, evaluate thesustainability of the company’sbusiness model. For example, thecollapse of the subprime mortgagemarket caused significantcollateral damage—some ofwhich was foreseeable and muchof which was not—to many companiesin different industries.Financially disruptive events mayoccur with little warning. However,if a company’s managementand board are aware of potentialvulnerabilities arising fromchanging market conditions andare willing to adapt their businessmodel and strategy, they may beable to reduce their exposure intime to avert a crisis.
Similarly, as economic conditionschange, it is important thatthe board is certain that it has theappropriate management team inplace to weather any crisis. Management’squalifications andcapabilities should be reassessedin terms of experience, expertise,commitment, leadership ability,and depth. Moreover, the boardshould make certain that the chiefexecutive officer knows that he orshe has the support of the boardfor the company’s strategic direction,if that is the case, or directorsshould communicate their concernsif there are any differeringviews on strategic direction.
An important part of thisprocess is making sure that theboard hears regularly from thechief executive officer’s directreports so it has sufficient confidencein the entire managementteam. This should be an importantcomponent of the board’ssuccession planning process aswell. These matters should beaddressed during the board’sexecutive session, which shouldbe on the agenda for each boardmeeting.
Minding the Store
Once directors have satisfiedthemselves that the businessmodel and the chief executiveofficer’s strategy continue to beappropriate, and that the currentmanagement team is capable ofeffectively managing the company’scurrent circumstances,directors should be sure theyunderstand the key elements ofthe company’s business performance.Directors should have aclear understanding of how revenuesources might react tochanging conditions in the economyin general or their industryin particular. For example, directorsshould have a general understandingof the company’s customerbase and whether it ischanging in meaningful ways.Directors also should have a goodoverall sense of the company’soperating costs, including laborand goods sold, as well as selling,general, and administrativeexpenses. Directors should take abroad view of the company’sfinancial and market position inorder to be able to ask managementabout potential vulnerabilitiesin performance, dependingon different economic scenarios.
Cash is King
Board members also need to focustheir attention on the company’sliquidity. This issue is especiallyimportant in today’s market environment.A clear understandingof the company’s cash flow andcredit arrangements, includingcovenant obligations, is vital.Directors should also be aware ofwhether the company’s businesshas a seasonal need for cash andbe assured that at the point of thecompany’s greatest need for cash,it will continue to have sufficientaccess to capital to meet the needsof its business. It is important thatmanagement can explain whatwill occur if cash flow is not asstrong as anticipated. For example,if a business downturn were tocoincide with a peak cash need,how severely would the company’sliquidity be affected?
Liquidity is Queen
Liquidity and its close cousin, solvency,are key in the merger andacquisition context. The failedpurchase of footwear retailerGenesco by its smaller competitorFinish Line is a cautionarytale. Finish Line attempted toacquire Genesco in a highlyleveraged transaction. The transactionhad no financing condition,but the financing commitmentprovided to Finish Line wascontingent on the solvency of thecombined company. Althoughthe strategic transaction appearedto be relatively certain of closingwhen it was announced, that wasno longer the case when, due to asharp decline in business, the solvencyof the combined companywas put in doubt.
In the merger and acquisitioncontext, directors should be carefulto examine the liquidity andsolvency risks, particularly inhighly leveraged transactionswhere financing is at risk, and considerthe impact on the companyif the transaction is announced,but fails to be consummated.
It is worth noting that, in thezone of insolvency, directors’obligations may shift from thecompany’s shareholders to thecompany’s creditors, dependingon which state law applies to thecircumstances. Under Delawarelaw, when a company is insolvent,the board’s priority potentiallyshifts to encompass theinterests of creditors. This is anarea that is highly dependent onspecific factual circumstances,and directors of a company facingpotential insolvency should seekexpert legal counsel in determiningthe parameters of their duties.
Directors should always focuson succession planning, but achallenging economic environmentincreases its importance. Ifa company experiences a downturnat the same time that thechief executive officer (or anotherkey member of management)exits without a clear successor, itwill be difficult for the board andthe remaining management teamto effectively deal with the challengesfacing the company. Asdirectors are considering contingencies,they should be mindfulof the succession plan andwhether it continues to be appropriatein light of changing circumstances,both internal andexternal.
Need to Know
Reporting and information systemsare the enemies of liability.Directors’ fiduciary duties do notchange with market conditions,nor does the applicability of thebusiness-judgment rule. Thedegree of vigilance required of adirector changes, depending onthe circumstances a particularcompany is facing. Directorsshould pay close attention to marketconditions and think carefullyhow trends or events affect thecompany’s business and strategy.As long as directors act on a fullyinformed basis, in good faith, andin the manner they reasonablybelieve to be in the best interestsof the company, their ordinary-coursebusiness decisions will receive the protection of the business-judgmentrule. In cases where thetraditional business-judgment rule applies,directors’ decisions are protected unless aplaintiff is able to carry its burden of proofin showing that a board of directors has notmet its duty of care or loyalty. In Delaware,it is clear that directors will only have liabilityin their oversight role in exceptionalcircumstances, such as when directorsutterly fail to implement any reporting orinformation system or controls; or whendirectors implemented such a system orcontrols, but consciously failed to monitoror oversee its operations, thus disablingthemselves from being informed of risks orproblems requiring their attention. Ineither case, imposition of liability requiresshowing the directors knew they were notdischarging their fiduciary obligations.
In light of recent cases, directors shouldactively seek information that will makethem “fully informed,” which is the keyprinciple at the core of the duty of care. Tobe fully informed, directors need to givedue consideration to relevant materialsand engage in appropriate deliberation. Adirector’s conscious disregard of his or herresponsibilities to the company—eitherthrough knowingly making decisions withoutadequate information and deliberationor through systematically ignoring aknown risk—will not satisfy the legalrequirement to act in good faith and on afully informed basis.
In this context, it is the responsibility ofthe directors to request information theyneed to make a fully informed decision, aswell as the obligation of the managementteam to provide sufficient information. Inturn, directors are entitled to rely on membersof management and other experts inmaking their decisions. Moreover, directorsshould not hesitate to ask the board’sadvisers for advice as to whether the informationprovided to them is sufficient forthem to make a decision.
Under Cover
In the current litigious environment, it isimportant to ensure companies have upto-date indemnification arrangements inplace for board members and that companieshave purchased adequate director andofficer liability insurance polices.
All of these arrangements should bereviewed on a regular basis to ensure thatdirectors have the fullest coverage availableto them so they are protected againstthe risk of personal liability for theiractions as directors. While director andofficer liability insurance polices havebecome more expensive, they are generallyavailable in most cases and should bepurchased. Retentions and exclusions ininsurance policies should be carefullystudied, so directors understand wherethey have protection and where they donot. Directors also should request informationabout the financial strength of thecompanies providing different layers of theinsurance coverage.
In addition, directors should considerthe impact of a bankruptcy of the companyon the availability of director and officerliability insurance. It is important tofocus on how rights are allocated betweenthe company, on the one hand, and thedirectors and officers, on the other hand,who may be claiming entitlement to thesame aggregate dollars of coverage. Inorder to eliminate any ambiguity thatmight exist as to directors’ rights to coverageand reimbursement of expenses in thecase of a bankruptcy of the company,many companies have decided to purchaseseparate supplemental insurancepolicies covering the directors and officersindividually (often known as “side-A”coverage) in addition to their standardpolicies. In the case of a bankruptcy, thiswill be money well spent.
Board directing is an active pursuit.Directors should satisfy themselves periodicallythat the company is pursuing the rightstrategic direction, that business and liquidityare sufficiently stable, and that managementis prepared for contingencies in bothits specific industry and the economy generally.If there are no storm clouds on thehorizon for a particular company, there isno need to schedule additional board meetingsor seek the advice of outside consultantssimply because economic conditionsare uncertain. That said, directors shouldstay in contact with management betweenboard meetings, particularly when externalevents occur that could potentially affectthe company’s business and strategy. Directorsmay request information from managementbetween board meetings and offercounsel to the chief executive officer orother members of management as appropriatefor their particular company. In avolatile business climate, directors shouldbe active, not passive, in exercising theiroversight responsibilities.
It is important to note that, absent anysubstantial reason to believe that the company’smanagement is not providingappropriate information or that managementis ignoring “red flags,” directors areentitled to rely on management’s reports,advice, and decisions.
David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz. Laura A. McIntosh is a consulting attorney for the firm.