Francis G.X. Pileggi

Top Five Cases from 2011
We begin with the top five cases on corporate and commercial law from Delaware for 2011 and we are glad to see that at least four of them have some support from the bench as these were the cases that four Vice Chancellors highlighted as important decisions in a recent panel presentation that they presented in New York City in early November 2011.  Those cases were the following:  In Re: OPENLANE Shareholders Litigation; In Re: Smurfit Stone Container Corp. Shareholder Litigation; In Re: Southern Peru Copper Corp. Shareholder Litigation and Air Products and Chemicals, Inc. v. Airgas Inc., and Kahn v. Kolberg Kravis Roberts & Co., L.P.

This article originally appeared on the Delaware Corporate & Commercial Litigation Blog.

In Re: OPENLANE Shareholders Litigation. In what many commentators referred to as a “sign and consent” transaction, in which the majority shareholders and the board of directors had sufficient control to provide the statutorily required consent, the Court of Chancery determined that the Revlon standard was satisfied and fiduciary duties were not breached notwithstanding the Omnicare case and even without customary safeguards such as a fairness opinion. See fuller summary here.

Kevin F. Brady

In Re: Smurfit Stone Container Corp. Shareholder Litigation. The Court of Chancery denied a motion for preliminary injunction and determined that the Revlon standard applied to a merger for which the consideration was split roughly evenly between cash and stock. See fuller summary here.

In Re: Southern Peru Copper Corp. Shareholder Litigation. In what may be the largest award granted in the Court of Chancery’s venerable history, a judgment was entered for $1.2 billion (later amended to $1.3 billion) for breach of fiduciary duties in connection with an interested transaction. With interest, the total is expected to be $2 billion.  The Court later awarded attorneys’ fees of 15 percent which amounts to $300 million in this derivative action. See fuller summary here.

Air Products and Chemicals, Inc. v. Airgas Inc. This magnum opus of over 150-pages in length will be the focus of scholarly analysis for many years to come. For purposes of this short blurb, it ended a year long takeover battle between two determined companies, with the Court of Chancery ruling, among other things, that the target company was not required to pull its poison pill when the board determined that the offer for the company was too low. See fuller summary here.

Kahn v. Kolberg Kravis Roberts & Co., L.P.  This Delaware Supreme Court decision reversed and remanded an opinion by the Court of Chancery interpreting “a Brophy claim as explained in Pfeiffer.”  The issue before the Court was whether a stockholder had to show that the company had suffered actual harm before  bringing  abreach of loyalty claim that a fiduciary improperly used the company’s material, non-public information (a Brophy claim).  The Supreme Court rejected that part of the Chancery’s decision in Pfeiffer v. Toll which requires a showing of actual harm to the company.  See fuller summary here.

We also selected the following additional noteworthy cases:

Shareholder Litigation

In Re: John Q. Hammons Hotels, Inc. Shareholder Litigation.  Despite the application of the entire fairness standard, the Court concluded that the merger price was entirely fair, the process leading to the transaction was fair, that there was no breach of fiduciary duty, and therefore no claims for aiding and abetting fiduciary duty.  See fuller summary here.

Reis v. Hazelett Strip-Casting Corp.  The Court applied an entire fairness analysis and held that the attempt to cash out minority shareholders via a reverse split was neither the result of a fair process nor did it involve a fair price.  See fuller summary here.

In re: Del Monte Foods Co. Shareholders Litigation. This first of three rulings enjoined a shareholder vote on a premium LBO transaction and the buyers’ deal protection devices.  The Court also held that the advice that the target board received from a financial advisor (who also did work on the deal for the bidder) was so conflicted as to give rise to a likelihood of a breach of fiduciary duty and the Court indicated that the financial advisory firm could face monetary damages due to aiding and abetting the potential breach.  See fuller summary here.

In re: Massey Energy Company Derivative and Class Action Litigation.  The Court declined to enjoin a proposed merger.  The Court noted that the derivative claims that the plaintiffs argued were not being fairly valued as part of the merger, would become assets of the surviving corporation.  The Court reasoned in part that the shareholders should decide for themselves whether to exchange their status as Massey stockholders for a chance to receive value from a third party in an arms-length merger.  See fuller summary here.

Frank v. Elgamal.  This decision exemplifies the different approach taken by different members of the Court in connection with an application for interim fees in a class action.  (Compare the different approach in the Del Monte case.)  See fuller summary here.

Krieger v. Wesco Financial Corp.  This decision determined that holders of common stock were not entitled to appraisal rights under Section 262 when they had the option of electing to receive consideration in the form of publicly traded shares of the acquiring company.  See fuller summary here.

In re: The Goldman Sachs Group, Inc. Shareholder Litigation.  In this first corporate opinion by Vice Chancellor Glasscock, the Court dismissed a derivative action brought against Goldman’s current and former directors based on a failure to make a pre-suit demand.  At issue was Goldman’s allegedly excessive compensation structure.  See fuller summary here.

Contested Director Elections
Genger v. TR Investors, LLC.  In this opinion, the Delaware Supreme Court addresses electronic discovery issues and contested elections for directors involving DGCL Section 225. See fuller summary here.

Johnston v. Pedersen.  This opinion determined that directors breached their fiduciary duties when issuing additional stock and as a result were not entitled to vote in connection with the removal of the incumbent board and the election of the new directors.  See fuller summary here.

Section 220 Cases
King v. VeriFone Holdings, Inc. This Delaware Supreme Court ruling reversed a Chancery decision that found a lack of proper purpose in a suit by a shareholder seeking books and records pursuant to Section 220.  Delaware’s High Court explained that it remains preferable to file Section 220 suits for books and records prior to filing a derivative suit, but holding that such a chronology is not, per se, a fatal flaw in a Section 220 action.  See fuller summary here.

Espinoza v. Hewlett Packard Co. This affirmance of Chancery’s denial of a §220 claim was based on the requested report to the board being protected by the attorney/client privilege.  (This is one of several decisions in this matter.) See fuller summary here.

Graulich v. Dell., Inc.  This is a Section 220 case in which Chancery denied a request for books and records due to the underlying claims being barred by a previous release and due to the shareholder not owning the shares during the period of time for which he was requesting documents.  See fuller summary here.

Alternative Entity Cases

CML V, LLC v. Bax.  This Delaware Supreme Court decision determined that creditors of an insolvent LLC are not given standing by the Delaware LLC Act to pursue derivative claims unlike the analogous situation in the corporate context.  See fuller summary here.

Sanders v. Ohmite Holding, LLC.  This decision clarified the rights of a member of an LLC that demanded books and records of an LLC.  The Court determined that pursuant to Section 18-305 of the Delaware LLC Act a member may seek records for a period prior to becoming a member of the LLC.  See fuller summary here.

Achaian, Inc. v. Leemon Family LLC.  This opinion addressed the transferability of interests of a member of an LLC and specifically whether one member of a Delaware LLC may assign its entire membership interests, including voting rights, to another existing member, notwithstanding the provision in an agreement that requires the consent of all members upon the admission of a new member.  See fuller summary here.

Jurisdictional or Procedural Issues
Central Mortgage Co. v. Morgan Stanley Mortgage Capital Holdings LLC.  In this decision, a Delaware Supreme Court determined that Delaware would not follow the standards for a motion to dismiss under Rule 12(b)(6) announced by the U.S. Supreme Court in the Twombly or Iqbal opinions.  See fuller summary here.

Hamilton Partners, LP v. Englard.  This decision addressed the issue of personal jurisdiction over directors and interlocking entities, as well as demand futility in the context of a double derivative shareholders suit.  (Although this was decided at the end of 2010, it was important enough to include in this list as it was issued after our deadline for our compilation last year). See fuller summary here.

Encite LLC v. Soni.  This decision rejected a request for an extension of a deadline for submitting expert reports because the Court did not approve an amendment to the Scheduling Order.  See fuller summary here.

Whittington v. Dragon Group.  In this latest iteration of multiple decisions in this long-running saga, the Court examines the doctrine of claim preclusion, issue preclusion and judicial estoppel.  See fuller summary here.

In re: K-Sea Transportation Partners, L.P. Unitholders Litigation.  This decision provides a useful recitation of the standard used in Chancery for deciding whether to grant a motion to expedite proceedings, and it also reviews language in a limited partnership agreement which arguably was an effective waiver of traditional fiduciary duties as allowed by the LP statute.  See fuller summary here.

Sagarra Inversiones, S.L. v. Cemento Portland Valderrivas, S.A.  This ruling determined that the standard of “irreparable harm” granting injunctive relief was not satisfied based on the financial condition of the defendant which was “not poor enough” to convince the Court that a money judgment would not make the plaintiff whole.  (This is one of several decisions in this matter.) See fuller summary here.

ASDC Holdings LLC v. The Richard J. Malauf 2008 All Smiles Grantor Retained Annuity Trust.  This decision discussed the enforceability of forum selection clauses and in particular when those clauses will be enforced despite a related case being filed first in another forum.  See fuller summary here.

Gerber v. ECE Holdings LLC.  This decision discusses the difference between a motion to supplement and a motion to amend a complaint.  See fuller summary here.

Advancement
Fuhlendorf v. Isilon Systems, Inc.  This decision addresses the advancement of fees incurred by officers and directors sued in connection with their corporate roles.  The specific issue in this case was whether the corporation should pay for all of the costs of a Special Master appointed to review the interim application for fees.  The case also discusses the common procedure employed to review disputed monthly legal bills in advancement cases.  See fuller summary here.

Receiver or Dissolution
Pope Investments LLC v. Benda Pharmaceutical Inc.  This decision rejected the application for the appointment of a receiver on the grounds that while the plaintiff demonstrated that the defendant was insolvent, the plaintiff failed to show that “special circumstances existed which would warrant the appointment of a receiver.”  See fuller summary here.

Stephen Mizel Roth IRA v. Laurus U.S. Fund, L.P.  This decision rejected a request to dissolve a limited partnership and refused to appoint a receiver in the context of an investment fund that was in liquidation mode but was not dissolved, nor was it winding-up as that term is used in the statute.  See fuller summary here.

Legal Ethics
BAE Systems Information and Electronics Systems Integration, Inc. v. Lockheed Martin Corp.  This opinion addresses Delaware Lawyers’ Rule of Professional Conduct 3.4(b) and discusses those situations in which a fact witness may be compensated for the “lost time” away from his “day job” suffered while testifying.  See fuller summary here.

Judy v. Preferred Communications Systems, Inc.  This decision addresses the issue of legal ethics involved in determining whether an attorney may assert a retaining lien over the documents of a former or delinquent client.   See fuller summary here.

Common Law v. Statutory Claims
Overdrive, Inc. v. Baker & Taylor, Inc.  In this last formal decision  by Chancellor Chandler, the Court discussed how the Delaware Uniform Trade Secrets Act displaces conflicting tort and other common law claims that are grounded in the same facts which would support the statutory misappropriation of trade secret claims.  See fuller summary here.

Damages for Breach of Agreement to Negotiate in Good Faith
PharmAthene, Inc. v. SIGA Technologies, Inc.. This Court of Chancery decision awarded damages for breach of a contractual obligation to negotiate in good faith and fashioned an equitable remedy that required the sharing of profits from the production of a product that the defendant failed to negotiate the license of in good faith. There are several decisions involving contract law by the Court of Chancery in this matter, the most recent ruling denying a motion for reargument. See fuller summary of the most recent decision here.

Postscript
On a final note, the last week of 2011 saw the sudden and sad passing of one of the nation’s foremost experts on alternative entities, Professor Larry Ribstein, who was often cited in opinions of the Delaware Courts. He coined the word “uncorporations” to refer to alternative entities and was the author of many treatises, law review articles and other publications on uncorporations, jurisdictional competition, the business of law firms and related topics involving the intersections of law and business. He was an iconic figure in the law, and the legal profession is better because of his many contributions.

“Our investigation reveals that there were few lines the executives were willing to cross to win the contract,” said SEC Enforcement Director Robert Khuzami in a conference call on the charges this morning, noting that Siemens executives allegedly approved up to $100 million in illegal bribes.

Recipients of those bribes allegedly included two presidents and cabinet ministers in two Argentinian administrations between 1996 to 2007. Of the funds used in the bribery scheme, approximately $31.3 million were made after March 2001, when Siemens became a U.S. issuer.

“One of the most critical functions of law enforcement is to communicate that businesses are not fools or dupes for obeying the law, we want to reward those companies that refuse to pay bribes. The best way to do that is to root out their competitors that are,” said Khuzami. “Business should flow to the company with the best product and the best price, not the best bribe. Corruption erodes public trust and the transparency of our commercial markets, and undermines corporate governance.”

Siemens, as a company, previously faced similar charges and paid $1.6 billion to resolve them with the SEC, U.S. Department of Justice and the Office of the Prosecutor General in Munich. Lanny A. Breuer, U.S. Department of Justice assistant attorney general for the DoJ’s criminal division, noted the value of Siemens’ assistance in bringing charges against the individual former executives. “It absolutely should be said that Siemens was remarkably cooperative and helpful throughout our investigation,” said Breuer. “Foreign bribery and corruption undermine fair market competition and create instability.”

The individuals charged in this case, according to an SEC press release, are:

• Uriel Sharef  – A former managing board member at Siemens from July 2000 to December 2007. He met in the United States with payment intermediaries and agreed to pay $27 million in bribes to Argentine officials in connection with the DNI contract.
• Ulrich Bock – Former commercial head of major projects for Siemens Business Services (SBS) from October 1995 to 2001. As the officer responsible for the DNI contract, he authorized bribe payments to Argentine government officials.
• Stephan Signer – Replaced Bock as commercial head of major projects for SBS and later became head of business operations and finance at Siemens IT Solutions and Services. He authorized the payment of bribes to government officials in Argentina.
• Herbert Steffen – CEO of Siemens Argentina from 1983 to 1989 and again in 1991, and group president of Siemens Transportation Systems from 1996 to 2003. Due to his longstanding connections in Argentina and Latin America, Steffen was recruited by Sharef and met directly with Argentine officials and offered bribe payments on behalf of Siemens.
• Andres Truppel – CFO of Siemens Argentina from 1996 to 2002. He regularly communicated with Argentine government officials regarding illicit bribe payments and participated in U.S.-based meetings where bribes were negotiated and promised.
• Carlos Sergi – A former board member of Siemens Argentina and a business consultant for Siemens Argentina. His primary role was to serve as a payment intermediary between Siemens and Argentine government officials in connection with the DNI contract.
• Bernd Regendantz – CFO of SBS from February 2002 to 2004. He authorized two bribe payments totaling approximately $10 million on Siemens’ behalf.

Harry Cendrowski (l) and Walter McGrail (r).

Whistleblowers often face significant pressure to remain quiet rather than report unlawful actions.  Though many whistleblower laws including Dodd-Frank contain anti-retaliation protection, evidence demonstrates that whistleblowers risk, in the words of the Senate Banking Committee, “committing ‘career suicide.’” Recent studies, including those highlighted in testimony before the House Financial Services Subcommittee on Capital Markets, indicate between 82 percent and 90 percent of whistleblowers are fired, quit under duress, or are demoted. For individuals working in a geographical area with few employers, or in an industry with little competition, the effects of whistleblowing can be substantial.  Whistleblowers may find themselves ostracized by local, regional, and national businesses for their actions. They may also face adverse social consequences.

In light of these consequences, whistleblowers often desire retaliation protection and anonymity.  Whistleblower provisions of Dodd-Frank provide for anti-retaliation protection and state that the SEC will protect the identity of the whistleblower to the largest extent possible; however, a whistleblower must satisfy numerous conditions to receive these benefits.  For example, a recent court ruling, Egan v. TradingScreen, Inc., found that a whistleblower must provide information regarding unlawful actions to the SEC in order to state a retaliation claim.  Whistleblowers reporting information solely to boards of directors and executives of their employing organization may not necessarily receive retaliation protection in spite of Dodd-Frank’s encouragement of such actions.

Additional conditions imposed by Dodd-Frank effectively incentivize individuals to report unlawful, tax-related actions to the IRS as opposed to the Commission.  For example, according to the SEC:

“…[Dodd-Frank] would authorize disclosure of information that could reasonably be expected to reveal the identity of a whistleblower…For example, in a related action brought as a criminal prosecution by the Department of Justice, disclosure of a whistleblower’s identity may be required, in light of the requirement of the Sixth Amendment of the Constitution that a criminal defendant have the right to be confronted with witnesses against him.”

Other Dodd-Frank provisions seemingly protect the confidentiality of whistleblowers in civil actions brought by the SEC or related government body.  However, because numerous exceptions exist to these confidentiality provisions, a whistleblower would likely assume he would eventually be exposed.  In contrast, the IRS can initiate an audit of tax records without likely subjecting the whistleblower to the Sixth Amendment.  Audits occur in the normal course of business and, barring appeal, do not require legal action or disclosure of a whistleblower’s identity.  As such, a whistleblower with knowledge of unlawful tax-related actions would likely select to report the issue to the IRS as the Service may be better able to protect his identity.  For example, the IRS recently paid a whistleblower $4.5 million for providing a tip that netted the IRS $20 million in taxes and interest.  The identity of the whistleblower, who worked for a Fortune 500 professional services firm, remains anonymous.

In addition to anonymity concerns, whistleblowers are monetarily incentivized to report unlawful actions to the IRS.  Under Dodd-Frank whistleblower provisions, the SEC must pay an award of between 10 and 30 percent of the amount recovered to eligible whistleblowers.  Section 7623 of the Internal Revenue Code, however, “mandates a whistleblower award of between 15 and 30 percent of the amount recovered” by the IRS.  While the upper bound of the potential bounty received by a whistleblower is 30 percent in both instances, the IRS is required to minimally pay a 50 percent larger award than the SEC for information resulting in successful enforcement of unlawful actions.

Whistleblowers may also turn to the IRS over the SEC due to the concept of materiality.  In enforcing securities laws (including the Sarbanes-Oxley Act of 2002), the SEC is largely concerned with matters that are material to financial statements, as these matters may change, according to the Financial Accounting Standards Board, “the judgment of a reasonable person” relying upon them.  The concept of materiality thus constrains the SEC’s actions:  if the SEC feels an item is immaterial, the Commission may forego investigation of the issue, and the whistleblower will not receive a monetary reward.  The concept of materiality, however, largely does not apply to tax assessments.  Thus, a whistleblower with knowledge of tax issues is incentivized to report the issue to the IRS as the Service is unconstrained by the concept of the materiality; the IRS may elect to investigate an issue that the SEC would otherwise not investigate.

Lastly, the IRS’s organizational structure, with its separate whistleblower office, may incentivize potential whistleblowers to report their concerns to the Service as opposed to the Commission. Currently, the SEC lacks an independent whistleblower office to handle tips.  While Sean McKessy was recently tapped to head the SEC’s whistleblower office, the office remains under the direct supervision of Robert Khuzami’s Division of Enforcement:  McKessy does not report directly to SEC Chairman Mary Schapiro.  On the contrary, the IRS has a separate, independent whistleblower office, which serves as the central repository for all whistleblower claims.  The director of this independent office reports to the IRS Commissioner, decreasing the possibility that a claim remains uninvestigated by lower-level IRS managers.  This difference in structure between the SEC’s whistleblower office with that of the IRS was highlighted in a May 10, 2011 letter by Sen. Charles Grassley to Mary Schapiro.  Sen. Grassley is the author of numerous whistleblower protection statutes, including the 2006 amendments to the IRS whistleblower program and Sarbanes-Oxley whistleblower protections for employees of publicly traded companies.

While numerous politicians and practitioners have applauded the whistleblower provisions of Dodd-Frank, these provisions are less attractive to potential whistleblowers than those already existing in the Internal Revenue Code.  With respect to tax-related issues, a whistleblower is likely incentivized to report issues to the Service rather than the Commission due to greater perceived anonymity and monetary rewards; a lower materiality threshold for tax assessments than financial statements; and the administrative structure of the IRS and SEC’s whistleblower programs.  Unless these provisions are substantially modified, Dodd-Frank represents at best an incremental step in incentivizing whistleblower activity for tax-related issues.

Harry Cendrowski is a founding member and Walter McGrail is a senior manager of Cendrowski Corporate Advisors.

Chancellor William B. Chandler III

“I want to pursue new and exciting opportunities and challenges that are available to me,” said Chandler. “I also believe now is the time for me to seek greater financial rewards in the interest of my family.”

In the cover story in the December/January issue of NACD Directorship, Chandler spoke of his legacy as chancellor. “To me, the most important case I have worked on is the one I’m working on right now. Whether it’s Disney or the dissolution of a failed start-up company—all of my cases are equally important. Some of the smaller disputes involving micro-cap companies frequently generate some of the most important principles and ideas in our jurisprudence. I will have to leave it to others to assess which cases define my legacy.”

Chandler’s resignation—described as a surprise by the Delaware News-Journal, which broke the story—creates a vacancy that will be filled.

According to the Delaware News-Journal, Chandler is being aggressively wooed by several top-tier international law firms. Among the contenders to succeed Chandler is Vice Chancellor Leo W.  Strine Jr., according to Charles Elson. The director of the University of Delaware’s Weinberg Center for Corporate Governance told Bloomberg that Strine, appointed in 1998, is now the court’s most senior judge. Any successor must be nominated by Markell, a Democrat, and approved by state legislators. Strine served as counsel to former Delaware Gov. Thomas R. Carper, who is now one of Delaware’s two senators.

Lord Peter Goldsmith

The Act is not going to go away. Of this Goldsmith is certain. Many business leaders both here in the U.S. and overseas have seen the delay in its release as an opportunity to lobby the government to change or scrap the rule. They fear its broad scope will significantly damage the ability of companies to do business and exposes directors and management to undue risks. “The legislation will not be changed,” he says. “That is not going to happen. It would take too long to do. The guidance is plainly in draft already—we know that.”

When will final guidance be released? Goldsmith expects the government to act this spring followed by a three- or four-month grace period. The delay is, in his eyes, understandable: “The legislation took a long time to build and certain elements, mainly the new provision making it a corporate offense to prevent bribery, were controversial. It was partially sold on the grounds that the government would provide adequate procedures and guidance but when they got into it the guidance was a lot tougher to write than anyone thought. So they are rightly taking their time with it.”

The focus of complaints from business leaders is that the rule is too broad. Unlike the Foreign Corrupt Practices Act (FCPA), which applies specifically to payments made to government officials, the U.K. Bribery Act applies to any individual or group and to almost any type of payment made to encourage someone to conduct business with a company.

The problem, according to opponents, is that there are many legitimate business payments and activities that could fall under the rule. When the rule first emerged, many companies completely ceased the practice of corporate hospitality. Is that a legitimate concern? While sensitive to the concern, Goldsmith does not believe so. He cites the example of a U.K. company that, in the natural course of doing business, brings a potential investor or partner to the U.K. to visit a production facility in the Midlands. The company provides airfare, lodging, food and other related expenses for the duration of the visit. “This would probably not be a problem,” he says. But if the company was to bring the entire family and put them up in a fancy, five-star, no-expenses-spared luxury London hotel, “Well, that will not work,” he says. The obvious problem is that there is so much in between. And, it is exactly this “in between” that managers are concerned about.

“I can understand the concern because the guidance is not there. What is being said is that reasonable and proportionate hospitality is fine but what does reasonable and proportionate mean? That is one of the big issues that the guidance has to deal with and I think it is going to be quite difficult for them [the U.K. government] to deal with it.”

Given the very real likelihood the official guidance will be at best vague on this issue, Goldsmith suggests some simple tests to apply to corporate entertaining expenses:

Be reasonable – would a reasonable person question the size or type of spending? Is it the sort of thing that your auditor will pass without raising an eyebrow? Is it something you could justify easily in public?

While companies are very worried about the potential impact of the Act, Goldsmith points out that perhaps the most important precaution for a company, and especially its board of directors, to mitigate the risk of falling afoul of new laws is to formalize a compliance program. “In short, it is about preparation,” he explains.

Richard Alderman, director of the U.K.’s Serious Fraud Office, has told companies that “if we can see a company that has thought about this and has produced a policy that is internally consistent and that they actually apply then we are very unlikely to criticize them for what they are doing.”

Goldsmith agrees: “Preparation of a robust compliance program is going to be the best defense against all of this”

This is good news for U.S.-based companies that are used to dealing with the FCPA as many of them already have robust compliance and fraud detection programs in place. That takes them a long way down the road to full compliance with the U.K. law. What might be even more important is that, unlike in the U.S. where a compliance plan is not a defense but may garner leniency at sentencing, the mere existence of a compliance program could well be an affirmative defense in the U.K.

Howard Goldstein

The NACD biannual General Counsel Advisory Board meeting, co-chaired by Fried Frank, offered an opportunity to preview the regulatory environment and provide recommendations for what should be on the working agenda of every public company director when meeting with general counsel. The consensus was that growing cooperation among enforcement agencies—including the Department of Justice, Securities and Exchange Commission and the Federal Bureau of Investigation, along with their regulatory and enforcement counterparts overseas— is likely to perpetuate the increase in enforcement and prosecution activity under both the FCPA and Britain’s soon-to-be implemented Bribery Act.

“At the end of the day, it’s all about prevention and how we are going to position ourselves within our respective organizations,” said Joseph Polizzotto, managing director and general counsel for the Americas at Deutsche Bank. “I would rather prevent the problems in the first place. This is a good moment in time for general counsel to be assertive.”

In addition to the onset of enforcement under the Bribery Act and stepped-up FCPA activity, at least two provisions of the Dodd-Frank Act are also likely to increase investigations, according to Fried Frank Partner William F. Johnson. The SEC is now studying whether broker-dealers should be subject to a federal fiduciary duty and has recently promulgated regulations that could provide sizable payments to whistleblowers in successful prosecutions. Johnson noted that “continued political pressure for investigations in capital markets will continue to ramp up the pace of investigations as shown by the recent uptick in cases related to subprime and CDO exposures.”

William Johnson

A regulatory provision that would allow money to be paid to individuals whose whistleblowing results in a successful prosecution is a purely American phenomenon. There are no such rewards for whistleblowing in the U.K., said James Kitching, who practices in Fried Frank’s London office, adding, “The emerging consensus is that the introduction of a reward would be seen as a retrograde step for the U.K.”

Howard W. Goldstein, a litigation partner at Fried Frank since 1990, was serving as an assistant U.S. attorney in the Southern District of New York when the FCPA was passed by Congress in 1977. For years, there was little if any enforcement, but two months before the close of 2010, there were some 40 FCPA-related cases pending.

Moreover, FCPA settlements continue to set records, and Goldstein predicts that cases “will continue to grow bigger and bigger.” Companies settling FCPArelated charges in 2010 paid a record $1.8 billion in financial penalties to the DOJ and SEC, according to the FCPA website. That compares with $641 million in 2009 and $890 million in 2008, the year of Siemens’ $800-million settlement, still the largest ever.

Referring to a recent FCPA case in which the company’s general counsel played a key role in investigating and preventing a fraud scheme, Johnson said that the GC’s actions could prove useful to others who might need help convincing their boards or CEOs that compliance programs should be improved or expanded: “The fact that the general counsel got some credit for stopping this scheme is something companies should want. It’s definitely something that makes both the company and the general counsel look good.”

Joseph Polizzotto

FCPA investigators could begin to use wiretaps, Goldstein said, given the predilection of the courts to allow conversations gleaned from professional eavesdropping into evidence as witnessed in the ongoing insider-trading case now underway against Galleon Group executives and employees.

Johnson, who worked at the SEC and was chief of the Securities and Commodities Fraud Task Force in the U.S. Attorney’s Office for the Southern District of New York prior to joining Fried Frank in 2009, said that many banks have strong internal compliance programs, but that non-financial services companies also need to address this area too: “The SEC is under no obligation to alert a company if a problem arises, so companies need to be proactive about ensuring their compliance programs adhere to high standards.”

The assembled GCs were also advised to be aware of the Bevill Test, adopted by the Ninth Circuit Court in US v. Graf, which sought to clarify the standard on whether a corporate employee has a special privilege with inside counsel. “In-house counsel should clearly state to any employee that you represent the entity and not the individual,” Johnson said.

The outcome of the global Innospec case, settled for $40 million, was also significant because it raised questions about London’s Serious Fraud Office (SFO)—the independent government department that investigates and prosecutes complex cases of fraud and corruption—and its adoption of more American-style strategies such as plea bargaining, settlements and protection from prosecution. Multinational companies are also likely to place greater emphasis on achieving global settlements, though it is unclear to what extent that will be achievable in light of the decision of the U.K. Court in Innospec.

Goldstein anticipates a major shift once the Bribery Act goes into effect, with greater cross-border cooperation in the investigation and enforcement of corruption offenses. A striking example of this new cooperation, he pointed out, occurred last year when a sting operation at a conference in Las Vegas involving the FBI, DOJ and City of London Police resulted in the arrests of 22 executives on bribery charges under the FCPA.

The upper limit of sanctions for bribery offenses in the U.K. will also be much more severe than under the FCPA. In the United States, settlements are more common. Under the Bribery Act, Kitching points out, “Maximum penalties are ten years imprisonment and unlimited fines.”

Other penalties upon conviction can include disbarment from public procurement contracts and disqualification from acting as a company director. “Notably, the sentencing judge in the Innospec case observed that corruption is much more serious in terms of both culpability and harm in cartel-type offenses,” Kitching said, “where the level of fines imposed is now very substantial and measured in tens of million of pounds.”

Participants:
Matthew Biben – Chief Administrative Officer, Senior Vice President, General Counsel; Next Jump

Chris Clark – Publisher, NACD Directorship

Paul Golding – General Counsel, Citi Infrastructure Investors

Howard W. Goldstein- Litigation Partner, Fried, Frank, Harris, Shriver, and Jacobson, New York

William F. Johnson – Litigation Partner, Fried, Frank, Harris, Shriver, and Jacobson, New York

James Kitching – Litigation Partner, Fried, Frank, Harris, Shriver, and Jacobson, London

David Maryles – Director, Legal, BlackRock

Robert Masters – SVP, Chief Compliance Officer, Secretary, General Counsel; Acadia Realty Trust

Jason Ment – Chief Compliance Officer, General Counsel; StepStone

Joseph Polizzotto – Managing Director, General Counsel; Deutsche Bank

Scott Posner – Assistant General Counsel, Terex Corp.

Alexander Simpson – Vice President, Corporate Secretary, General Counsel; Reis

Will Terrill – Vice President, U.S. Flag Services, Intermarine, LLC

Judy Warner – Managing Editor, NACD Directorship and directorship.com

ADDITIONAL STORIES IN THE DIRECTOR’S GUIDE TO LIABILITY:
Risks Rising
Litigation 101: You’ve Been Sued. Now What?
The Ultimate Insurance Check List
Avoiding the “F” Word: How Your External Auditor Can Help You Avoid Fraud

Nose coverage: Claims-made liability policies typically include a retroactive date, and the policy will not cover claims arising from covered occurrences, acts, or omissions committed prior to that date. The period between the inception date and retroactive date. It gets its name from its attachment to the “front” of the policy term, as opposed to its “tail.”

Policyholder surplus: The difference between an insurer’s admitted assets and liabilities, i.e., its net worth. This figure is used in determining the insurer’s financial strength and capacity.

Reservation of rights: An insurer’s notification to an insured that coverage for a claim may not apply. Such notification allows an insurer to investigate (or even defend) a claim to determine if coverage applies (in whole or in part) without waiving its right to later deny coverage based on information revealed by the investigation. Although a reservation of rights protects an insurer’s interests, it also alerts an insured to the fact that some elements of a claim may not be covered, thereby allowing the insured to take necessary steps to protect its potentially uninsured interests.

Runoff: A provision in a reinsurance contract stating that the reinsurer remains liable for losses under reinsured policies in force on the termination date, that result from occurrences taking place after the termination date.

Severability of exclusions: A term stating that although an exclusion applies to one (or more) insured(s) under a policy, the exclusion does not necessarily apply, and therefore bar coverage, as respects other insureds. Assume that a directors & officers liability policy excluding coverage for fraudulent and criminal acts also contains a severability provision that applies to the policy’s exclusions. Under these circumstances, the fraudulent actions of one director would not bar coverage for other directors who were not a party to these fraudulent acts (that bar coverage for the director who committed them).

Several liability: Liability that may be assigned or apportioned separately to each of a number of liable parties. Distinguishable from, but often paired with, joint liability.

Side A coverage: The section of coverage under a directors and officers liability insurance policy affording “direct” coverage of an organization’s directors and officers. This portion of the policy provides direct indemnification to the directors and officers for acts that the corporate organization is not legally required to indemnify the directors and officers.

Side A ONLY coverage: A directors and offices liability policy that provides only “direct” coverage of the directors and officers, but does not cover the corporation’s legal obligation to indemnify the directors and officers. Side A-only forms are written on either an excess or umbrella basis over a primary D&O policy. When written on an excess basis, they provide additional limits if a claim exhausts the coverage available under the primary form. When written on an umbrella basis, Side A-only policies afford broader coverage than the underlying, primary D&O policy, as well as additional limits.

Side B coverage: Another term for what is known as the “Corporate Reimbursement Coverage” section of a directors and officers liability policy.

Side C coverage: Another term for what is known as the “Entity Securities Coverage” section of a directors and officers liability policy.

Tail: Claims from workers compensation and liability exposures in a given period can arise for many years thereafter. The aggregate of such incurred but not reported (IBNR) losses is often called tail liability.

Tail coverage: A claims-made liability policy covers claims made prior to the policy’s expiration or cancellation that arise from covered occurrences, acts, or omissions committed on or after their retroactive date, if any.

Source: International Risk Management Association (www.irmi.com)

In the recent Selectica v. Versata decision, the Court reiterated well established law upholding garden-variety poison pills and applied those concepts to a different type of pill that carries a low trigger threshold of 4.99 percent designed to protect a company’s tax net operating loss carry-forwards (NOLs).  Beyond upholding an increasingly popular adaptation of the traditional poison pill, the decision serves as a useful reminder of the issues that every director and advisor should consider in crafting corporate defenses.

In the current environment, anti-takeover protections have received renewed focus from all quarters, as target boards, concerned with depressed stock prices, confront opportunistic buyers, while, at the same time, shareholders and institutions increasingly emphasize good corporate governance and board accountability.  One such anti-takeover tool is the shareholder rights plan, or “poison pill”, which has seen a resurgence of sorts, with new pill adoptions expanding in 2008 for the first time since 2004-2005, according to Shark Repellent.

Poison pills are typically structured as rights issues that, once triggered, allow all stockholders (other than the triggering stockholder) to purchase shares at a dramatic discount to market (this is often called the “flip-in” feature).  The classic poison pill is designed to prevent a bidder from acquiring the corporation without the consent of the target board.  Usually, the rights are triggered by an acquisition of between 15 and 20 percent of the company’s outstanding stock, and, prior to that trigger point, the board retains substantial latitude to modify or eliminate the pill in the context of a friendly transaction.  In a hostile acquisition, an acquirer may always pursue a proxy fight or other route to take control of the board, and, once in that position, remove the pill in order to permit an acquisition to go forward.  When used appropriately, poison pills have generally been upheld by courts, including in Delaware.

As necessity is the mother of invention, some companies with significant tax net operating losses (NOLs) have turned to a pill with a low trigger threshold of 5 percent or less to protect those assets against any limitation on their use under Section 382 of the Internal Revenue Code.  Limitations are generally imposed if there is a more than 50 percent increase in the ownership of a company’s stock by 5 percent shareholders over a three-year period.  While still a minority of overall pill adoptions, instances of these so-called “NOL” or “382 pills” have increased from a mere 5 percent of all pills adopted in 2007 to 30 percent of all pills adopted in 2009, according to Shark Repellent.

Selectica was a company with significant NOLs.  While NOLs are an inherently contingent asset (because they have value only if the company has taxable income to offset), Selectica’s board received expert advice that it had NOLs of over $160 million.  The board engaged experts on several occasions to analyze the NOLs’ value and was acutely intent on avoiding impairment under Section 382.

Trilogy was a competitor with a contentious relationship with Selectica, marked by patent conflicts and unsuccessful attempts to acquire Selectica, that had begun making open market purchases of Selectica’s stock after its acquisition proposals were rejected. When Selectica realized that Trilogy had amassed 5 percent of its shares, the board again retained experts to analyze the likelihood of NOL impairment and was advised of a substantial risk.  Accordingly, the board lowered the trigger threshold for its existing poison pill from 15 percent to 4.99 percent, grandfathering existing 5 percent shareholders.  Further, the board took the additional step of creating an independent committee to review the pill periodically, including the trigger threshold, and determine whether it remained in shareholders’ best interests.

Despite the 4.99 percent threshold, Trilogy continued buying Selectica stock and intentionally triggered the pill.  After considering several options and consulting with its advisors, the Selectica board opted to employ a share exchange feature in the pill, rather than the more dilutive flip-in feature, and then “reloaded” the pill by issuing new rights.  As a result, Trilogy’s ownership was diluted from 6.7 percent to 3.3 percent; far less dilution than it might have suffered under the pill’s flip-in.  Selectica then filed a motion for declaratory judgment that the NOL pill and share exchange were valid, which Trilogy contested.

In upholding Selectica’s actions, the Court applied the analysis established by Unocal v. Mesa Petroleum and its progeny.  Under Unocal, a board’s defensive actions when facing a possible change in control are subject to enhanced scrutiny because of the “omnipresent specter” that the board may have acted in its own interests and not those of its shareholders.  To have the protection of the business judgment rule, a board must establish that it had “reasonable grounds for believing that a danger to corporate policy and effectiveness existed”, which necessarily include elements of good faith and reasonable investigation, and that its actions were reasonable in relation to the threat posed, and neither coercive nor preclusive.

While Selectica does not represent a significant departure from existing Delaware decisions, the Court, in its application of Unocal, provides at least two important reminders for boards of directors.  First, reasonableness must underlie board action, and perfection is not required.  Based upon extensive expert advice and analysis, the Court determined that the board reached a reasonable conclusion that Selectica’s NOLs represented a valuable corporate asset that was worthy of protection.  Having reached that conclusion, the Court held that a board’s response to a threat against those assets need only be proportionate, not the most narrowly or precisely tailored.

Second, key to establishing reasonableness is a record showing a considered and extensive process, strengthened by expert advice where appropriate.   At each step in the process, the Selectica board built a record that established a basis for ascribing value to the NOLs as a corporate asset, weighed the risk to that asset and showed a measured response to the perceived risk.  Among other things, the Court noted the board’s attempt to find alternative solutions to Trilogy’s triggering of its pill and its adoption of the more moderate share exchange rather than the flip-in.

Notwithstanding the foregoing, we do caution that the Unocal analysis is fact based.  In addition to the facts surrounding the Selectica board’s process and actions, the Court noted that the board was faced not with an amorphous threat of NOL impairment, but with the specific threat of a competitor who sought to use the shareholder franchise to impair corporate assets.  The Court cautioned against companies using NOLs as a “pretext” and warned that NOL pills will continue to be carefully reviewed.  Thus, whether the Court would invalidate an NOL pill or any pill for that matter under different circumstances remains an open question.

Matthew W. Abbott and Steven J. Williams are partners in the corporate department of Paul, Weiss, Rifkind, Wharton & Garrison LLP.  Frances Mi, counsel in the corporate department of the firm, also contributed to the preparation of this article.

What is the risk?
The risk stems from the increasing willingness of the United States Department of Justice (DOJ) to prosecute senior officers and directors for civil and criminal violations under what is known as the Responsible Corporate Officer Doctrine (RCOD).  While it has always been the case that individuals who actively and intentionally participate in criminal activity have the potential to be prosecuted for their actions, law enforcers are now delving even deeper into the boardroom to apply heavy retrospective scrutiny to board members.  Their goal is to determine whether individual board members carried out their oversight responsibilities in a way that could have prevented allegedly illegal acts from occurring in the first place.

The RCOD enables prosecutors to attempt to hold a corporate officer or director vicariously liable for the criminal violation of a subordinate employee of the company under the following conditions (1) the officer occupies a position of responsibility and authority in the corporation, (2) has the power to prevent the violation, and (3) fails to do so.  The RCOD dramatically raises the stakes for directors, in particular, who may view themselves as far removed from the every day operations of the company.  Under the RCOD, senior officers and directors can be found liable for the illegal acts of other corporate agents, without proof that the officer or director directly participated in or authorized the act.

Nor is this personal risk only theoretical as recently demonstrated by the DOJ.  In January 2010, the DOJ announced an unprecedented issuance of indictments and arrests of senior corporate executives from several companies who allegedly engaged in activities prohibited under the Foreign Corrupt Practices Act (FCPA).  After a lengthy undercover operation spearheaded by the Federal Bureau of Investigation, the DOJ disclosed the following in its press release touting the results of its investigative efforts:

“Twenty-two executives and employees of companies in the military and law enforcement products industry have been indicted for engaging in schemes to bribe foreign government officials to obtain and retain business…The indictments stem from an FB undercover operation that focused on allegations of foreign bribery in the military and law enforcement products industry.

The 16 indictments unsealed today represent the largest single investigation and prosecution against individuals in the history of DOJ’s enforcement of the Foreign Corrupt Practices Act (FCPA), a law that prohibits U.S. persons and companies, and foreign persons and companies acting in the United States, from bribing foreign government officials for the purpose of obtaining or retaining business. The indictments unsealed today were returned on Dec. 11, 2009, by a grand jury in Washington, D.C.

In connection with these indictments, approximately 150 FBI agents executed 14 search warrants in locations across the country, including Bull Shoals, Ark.; San Francisco; Miami; Ponte Vedra Beach, Fla.; Sarasota, Fla.; St. Petersburg, Fla.; Sunrise, Fla.; University Park, Fla.; Decatur, Ga.; Stearns, Ky.; Upper Darby, Penn.; and Woodbridge, Va. Additionally, the United Kingdom’s City of London Police executed seven search warrants in connection with their own  investigations into companies involved in the foreign bribery conduct that formed the basis for the indictments.”

The indicted included directors, chief executive officers, senior vice presidents, and managing partners of various companies engaged in the manufacture and sale of military and law enforcement equipment.

According to a series of public comments made by DOJ officials last fall, the DOJ is now applying RCOD theories in civil and criminal anti-fraud enforcement actions across other industries, including the medical device and pharmaceutical manufacturing industries.  Given the federal government’s HEAT initiative and its strong focus on health care fraud and abuse, the DOJ, the Food and Drug Administration, and the Department of Health and Human Services Office of Inspector General may well be inclined to assert the RCOD against the officers and directors of health systems and other health care providers in circumstances involving allegations of substandard care or other False Claims Act scenarios.

The roots of the RCOD can be traced to two U.S. Supreme Court cases:  U.S. v. Dotterweich (1943), and U.S. v. Park (1975).  The RCOD has traditionally been applied in cases involving “public welfare” laws, e.g., food and drug, environmental and, significantly, securities laws.  Indeed, both the Securities Act of 1933 and the Securities Exchange Act of 1934 provide liability on the part of a “person who controls” a violator of the securities laws.  Of course, the Securities and Exchange Commission and the DOJ work closely together on matters that involve corporate fraud, such as that prohibited by the FCPA, and other securities-related violations.

The prosecutions associated with U.S. v. Norian Corp. are a prominent example of the DOJ utilizing the RCOD in the health care context.  In the Norian Corp matter, four corporate officers were indicted under the RCOD based on their involvement in conducting unauthorized clinical trials of a bone cement-oriented medical device for medical indications that were not approved by the FDA also known as “Off Label.”  In July, 2009 two of these executive officers pleaded guilty to a single misdemeanor charge for their involvement in these unauthorized clinical trials of medical devices.  As part of their guilty pleas, the executives stipulated that they were “responsible corporate officers” at the time the disputed clinical trials occurred.

Under egregious circumstances, the DOJ may exercise its prosecutorial discretion to pursue individual directors based on their action or inaction depending on the individual director’s role, on what committee’s the director served, and attendance or lack thereof at key board meetings. In certain regulated industries, officers and directors are obligated to certify the company’s compliance with critical regulatory obligations.  These certifications, of course, create a statutory “paper trail” that can lead directly back to the certifying director if it later turns out that the company was not in compliance with the necessary regulatory standards.  This use of the RCOD arises at the same time that the Delaware Chancery court and other courts are experiencing an increase in litigation asserting breach of fiduciary duty causes of action against corporate officers and directors–including officers who are not board members (e.g., the Supreme Court of the state of Delaware in Gantler v. Stephens reversed the Chancery Court’s dismissal of a shareholder complaint alleging conflict of interest and breach of fiduciary duty).  While much of this litigation has been prompted by the current political and economic environment, a director’s perceived lack of attention to his or her oversight duties can make him or her a target of both an RCOD criminal prosecution or civil breach of fiduciary duty claims.

What to do?
The re-emergence of the RCOD and the associated increase in the risk in personal liability should prompt directors to examine closely their own mode of operating as a board member.  We recommend that directors take a more active posture in educating themselves about law enforcement and regulatory initiatives that focus on their particular industry or company so that they will be in a better position to understand whether the company’s senior management is allocating sufficient resources to corporate compliance initiatives.  Board members should focus on how their overall board and board committee roles, such as the audit or compensation committees, create specific oversight responsibilities over key company functions that depend on robust regulatory compliance.

In particular, directors should be motivated to recognize specific “high regulatory compliance risk” situations so that they can evaluate the extent to which they are in a position to influence the actions of corporate subordinates to head off potentially illegal corporate activities.  Where there is a direct nexus, such as when dealing with foreign governments, U.S. government contracts, or U.S. regulatory limitations on product development or marketing activities to the public, directors should advocate that key employees receive proper regulatory compliance education, have their actions closely monitored in “real time” by the legal and compliance departments, and seek and receive executive and legal approval before moving forward.

These compliance initiatives often require the allocation of corporate resources to what are perceived as non-revenue creating activities.  The reality is, however, that many of these initiatives are critical to the development of an economically sustainable business model for the company and, consequently, a more consistently pleasant and rewarding experience for board members. and other measures intended to prevent lower level managers who report to them from engaging in noncompliant behavior.  The likelihood of success in preventing episodes that threaten the existence of the company and pose personal liability to directors is enhanced by insuring that senior management has enabled its employees to have access to regular compliance education and training from qualified internal resources and, where necessary, from the most qualified outside advisors.

T. Reed Stephens is a partner in the Washington, D.C. office of McDermott Will & Emery. He was a Department of Justice trial attorney from 1995 to 2003. Michael Peregrine is a partner with McDermott Will & Emery in the firm’s Chicago office.

On February 23, 2010, in Hertz Corporation v. Friend, the Supreme Court resolved that disagreement, ruling that “principal place of business” means “the place where the corporation’s high-level officers direct, control and coordinate the corporation’s activities,” commonly referred to as the corporation’s “nerve center.”

Background
Hertz operates its rental-car facilities in more than 40 states, with California accounting for the largest percentage of transactions as compared to other states. However, most of Hertz’s executive and administrative functions occur in its corporate headquarters located in New Jersey.

California plaintiffs brought a class action lawsuit in California state court, accusing Hertz of failing to pay overtime to location and branch managers. Hertz removed the case to federal court, claiming it was not a citizen of California, as it was incorporated in Delaware and had its principal place of business in New Jersey. The plaintiffs moved to remand the case back to the California state court, claiming the federal court lacked diversity jurisdiction because (they asserted) Hertz’s principal place of business was California, the state in which Hertz did the most business.

The federal district court in California agreed with the plaintiffs and remanded the case. Hertz took an appeal, which it was entitled to do under the Class Action Fairness Act, but the Ninth Circuit affirmed. The Ninth Circuit held that to determine a corporation’s “principal place of business,” a court must first determine the amount of business the corporation does in each state. If the amount is “significantly larger” or “substantially predominates” in one state, then that state is the principal place of business. If no such state exists, then the corporation’s “nerve center” is the principal place of business. Under this framework, the lower courts determined that Hertz’s principal place of business was California, rather than New Jersey.

The Supreme Court’s Decision
The Supreme Court rejected the Ninth Circuit’s framework.  After analyzing the legislative history, the various tests used by other courts, and other considerations, the Court held that considering the “nerve center” to be the principal place of business was the best option and would best achieve consistency. The Court concluded that this test is relatively easy to apply and does not require courts to weigh corporate functions, assets or revenues. The Court cautioned that should the record reveal attempts at jurisdictional manipulation—such as the “nerve center” being nothing more than a mailbox, a bare office, or the location of the annual executive retreat—the courts should consider the “nerve center” the place of actual direction, control, and coordination of the corporation’s business.

What Hertz Means for Employers
Plaintiffs often sue in state court, while defendant employers usually prefer federal court. The Court’s decision clarifies the test for determining the “citizenship” of corporations so that defendants now can more confidently determine whether the case can be removed to federal court.  Now, if an employer is sued in a state other than its state of incorporation or the location of its “nerve center,” the Hertz decision makes federal court a viable option, even if the employer does a substantial amount of business in the state where the lawsuit was filed (provided that no other defendant is a forum-state citizen and that the amount in controversy exceeds $75,000 in controversy or $5 million for a class action).

Marc Jacobs is a partner at Seyfarth Shaw resident in its Chicago office where he specializes in labor and employment law. This article was adapted from a recent Seyfarth Shaw client alert.

David Kistenbroker responded, citing the Galleon Capital case in which 21 people are accused by the Securities and Exchange Commission of making tens of millions of dollars in illegal profits by trading on nonpublic information. “Wiretaps are pretty tough—everyone is presumed innocent until proven guilty,” said Kistenbroker, noting that Galleon “is going to be broader than what we know of today.”

“I’ve seen the situation where the hedge fund is playing both sides of the aisle—the hedge fund is in on the debt side, helping capitalize and finance the company—and the guy down the hall is placed on the equity side—and they might have coffee or water- cooler talk,” said Kistenbroker as heads in the audience nodded in agreement. “It’s a danger for boards today and you may very well find yourselves calling for internal investigations.”

“All of us have gotten used to being very cautious of what is put in email,” added Stephanie Goldstein. She emphasized the need for corporate executives to utilize this “wake-up call,” reminding directors that anyone privy to non-public information should exercise caution.

“At what point do executive officers need to lawyer up?” asked Coffee. Lorie Almon emphasized the need to be proactive instead of waiting for the government to question a firm’s practices. “Resting on what used to work in the past is probably a very dangerous approach…forward thinking is the best approach a director can take right now.”

To that point, Almon pointed to a disturbing new trend of private plaintiff firms adding individuals to lawsuits in addition to corporations. “I do think there’s a trend, if not in the government, for private plaintiff firms to try to add directors—often you see motions to dismiss, but what we will have left is the ERISA case, the claims by stockholders that they no longer have the value they used to have and they want you [directors] in their lawsuits,” noted Almon.

“Stay informed, ask questions…what is in the pipeline and what the potential hazards [might be],” urged Goldstein.

The Supreme Court heard oral arguments this week in Free Enterprise Fund v. Public Company Accounting Oversight Board, No. 08-861, where the Court is expected to address the constitutionality of Congress’s creation of the Public Company Accounting Oversight Board through the Sarbanes-Oxley Act of 2002.

The Act requires, for the first time, that auditors of U.S. public companies be subject to external and independent oversight, charging the PCAOB with this responsibility. Although it has commenced few major enforcement actions, the PCAOB has significant authority over the rules and standards applicable to auditors of public companies; it recently adopted a new auditing standard and has proposed a suite of seven new standards.

The PCAOB also performs annual inspections of registered firms that regularly audit more than 100 public companies, and at least triennial inspections of all other registered firms. Specifically at issue here, the Court will consider whether Congress ran afoul of the Appointments Clause of the Constitution when it granted authority to appoint and remove Board members of the PCAOB to the Securities and Exchange Commission rather than the President.

BACKGROUND

In the wake of the collapses of Enron and Worldcom, Congress passed the Sarbanes-Oxley Act of 2002, which, among other reforms, created the PCAOB. The PCAOB, which consists of five members appointed by the SEC and removable by the SEC “for good cause,” is charged with overseeing auditors of public companies by registering public accounting firms, establishing audit and ethics standards, conducting inspections and investigations of registered accounting firms, and disciplining violators.

The PCAOB is subject to significant oversight and control by the SEC: among other restrictions: (i) the PCAOB could commence operations only upon SEC approval of its organization and procedures, (ii) its rules are effective only upon prior approval by the SEC, (iii) its existing rules may be modified by the SEC, and (iv) its adjudications are subject to de novo review by the SEC.

Free Enterprise Fund, a non-profit public interest organization, and Beckstead and Watts LLP, an accounting firm subject to a formal investigation by the PCAOB, brought a facial challenge against the constitutionality of the PCAOB’s creation in the United States District Court for the District of Columbia. Plaintiffs alleged that the Act’s creation of the PCAOB violated the Appointments Clause, the separation of powers doctrine, and non-delegation principles. Plaintiffs argued that the Act did not permit adequate Presidential control of the PCAOB, and that the absence of day-to-day supervision of the PCAOB by the SEC and the for-cause limitation on the SEC’s removal power meant the PCAOB’s Board members were not inferior officers and therefore must be appointed by the President.

Defendants—the PCAOB and the United States—moved for summary judgment. Defendants argued that the PCAOB was composed of inferior officers within the meaning of the Appointments Clause, and that the SEC is a Department that may be assigned appointment power. Accordingly, Congress had constitutional authority to vest appointment and termination authority in the SEC. The district court agreed and granted Defendants’ motion for summary judgment.

On appeal, the Court of Appeals for the District of Columbia Circuit affirmed the district court’s finding that the PCAOB Board members were inferior officers. The court reasoned that exercise of the PCAOB’s powers under the Act is subject to comprehensive control by the SEC and PCAOB Board members are accountable to and removable by the SEC. The court further determined that the Act ensures that all PCAOB functions are subject to pervasive SEC control, including approval of its annual budget and supporting fees.

The President’s ability to appoint and remove SEC Commissioners, and the Commissioners’ ability to appoint PCAOB Board members and remove them for cause, “preserves sufficient Executive influence over the Board through the Commission so as not to render the President unable to perform his constitutional duties.”  The court similarly rejected Plaintiffs’ argument that for-cause removal unconstitutionally limits the SEC’s removal power because the SEC’s power to change or limit PCAOB functions at will blunts the constitutional impact of for-cause removal.

The D.C. Circuit, like the district court, also rejected Plaintiffs’ contentions that, even if PCAOB Board members are inferior officers, they cannot be appointed by the SEC because the SEC is not a “Department” and the Commissioners of the SEC are not its “Head” within the meaning of Article II. The SEC is “Cabinet-like,” the court explained, because “it exercises executive authority over a major aspect of government policy, and its principal officers are appointed by the President with the advice and consent of the Senate.”

In his dissenting opinion, Judge Brett M. Kavanaugh of the D.C. Circuit observed that for-cause removal has long been criticized as inconsistent with the text of the Constitution. Noting that both SEC Commissioners and PCAOB Board members are only removable for cause, Judge Kavanaugh stated that the Act created a “double for-cause removal structure [that]. . . completely strips the President’s removal power and. . .poses a greater restriction on the President’s constitutional authority than a single for-cause provision.”

SUMMARY OF THE ARGUMENT

Before the Supreme Court, Plaintiffs-Petitioners argued that the Act violated the separation of powers by insulating the PCAOB from Presidential supervision and control and that the Act violated the Appointments Clause because the PCAOB members are not inferior officers and the SEC is not a Department Head. Petitioners asserted that the PCAOB is “unique among Federal regulatory agencies in that the President can neither appoint nor remove its members, nor does he have the ability to designate the chairman or review the work product, so he is stripped of the traditional means of control that he has over the traditional independent agencies.”

Justice Anthony M. Kennedy began by asking what harms or dangers other than the cost of compliance are “inherent in the power of the board unmonitored or unchecked by the SEC, to investigate?” Petitioners identified the cost of compliance and burdensome investigation beyond SEC review as among the chief hardships imposed by the Act. In clarifying the difference between a cabinet head and the SEC in response to Justice Sonia Sotomayor’s questioning, Petitioners stated that an independent agency is not subject to the President’s plenary control while a cabinet head is.

Justice Stephen G. Breyer inquired whether there is a law preventing the President from removing an SEC Commissioner without cause. Although there is no explicit prohibition on at-will removal of Commissioners, Petitioners noted that the SEC is modeled after the FTC and, under a prior case where the President was precluded from terminating membership in the War Claims Commission, one must look at the function of the agency in determining if removal is for cause or at will. Justice Breyer further pressed the Petitioners, noting that “if an executive officer appoints an inferior officer, which the executive officer can remove for cause, I can’t see a Constitutional problem.” Petitioners responded that the President cannot control the appointment of Board members.

Defendant-Respondent United States, represented by the Solicitor General’s office, maintained that the President has constitutionally sufficient control over the SEC, and the SEC has comprehensive control over the PCAOB. As such, the President has constitutionally sufficient control over the PCAOB. Justice Antonin Scalia, however, observed that “the Chairman [of the SEC,] which is. . .the knife that the President has into the SEC, has no role in the control of the Board.”

According to the Government, there is no difference between the SEC’s supervision of the PCAOB and the supervision of any other SEC function because the SEC could reach out and abrogate any PCAOB rules or promulgate its own rules, which includes delegating control of the PCAOB to the Chairman of the SEC. Chief Justice John G. Roberts responded, “Well the Board can act, and the SEC can, I suppose, retroactively veto their actions, but the SEC doesn’t propose what actions the Board takes, actions which can have significant, devastating consequences for the regulated bodies.”

Chief Justice Roberts then posed the question, “Why did Congress set up a separate Board if it was going to be entirely controlled by the SEC?” The Government replied that Congress did not want the PCAOB to compete with the “resource-strapped” SEC for resources. Additionally, by placing the PCAOB outside of the normal civil services laws, the PCAOB may attract employees it could not attract on normal civil service salaries. In response to the Government’s assertion that for-cause removal was previously approved by the Court, Chief Justice Roberts noted that the two for-cause removal provisions create “for-cause squared,” leading to a “significant limitation” that prior case law did not recognize.

Defendant-Respondent PCAOB similarly argued that the SEC has pervasive authority over the Board because: (i) the SEC can rescind the Board’s authority, (ii) Board inspections and investigations are subject to plenary SEC control, and (iii) the SEC controls the Board’s budget and salaries.

Justice Scalia asked the PCAOB’s counsel: “Do you know any parallel situation where there is a, supposedly, agency composed of inferior officers who have the power to tax the public unless it’s overturned by somebody else?” PCAOB replied that it is not an uncommon feature, but the most critical aspect of the Act is that the judgment and decisions of the SEC control the Board: “[T]he Board can propose, but it’s the SEC that decides.” Justice Scalia opined, “I think if the President called up the FCC and said, ‘I want you to rule this way,’ I think there would be an impeachment motion in Congress.”

IMPLICATIONS

In Free Enterprise Fund, the Court has the opportunity to clarify the extent to which Congress may assign appointment and removal authority to entities other than the President that are not directly controlled by the President. If the Court sides with the Petitioners-Plaintiffs, one of the centerpieces of the Sarbanes-Oxley reforms—the creation of the PCAOB— will be sidelined. But Congress and the Obama Administration could probably remedy that result by making members of the PCAOB directly appointed by the President (and still subject to removal only for cause) or by making members of the PCAOB removable at will by the SEC, as suggested by Chief Justice Roberts.

In the long term, however, a finding of unconstitutionality would place significant limits on the ability of Congress to create additional independent agencies or executive positions that are not directly subject to significant Presidential appointment and removal power.

Peter Bresnan and Jonathan Youngwood, litigation partners with Simpson Thacher & Barlett, contributed to this blog. Bresnan, based in Washington, is a former deputy director in the Division of Enforcement at the SEC. He can reached at pbresnan@stblaw.com. Youngwood, based in New York, regularly represents financial institutions and public companies in securities, corporate control and other complex litigation. He can reached at jyoungwood@stblaw.com. Bashiri Wilson is an associate with Simpson Thacher & Barlett who contributed to this article.

An Increase in Claims
Charges filed with the U.S. Equal Employment Opportunity Commission rose 23 percent, to 32,690, in the year ending Sept. 30, 2008. Retaliation claims represent more than a third of all claims filed with the agency and are expected to steadily increase. Indeed, EEOC officials have publicly stated that eradicating retaliation is the Commission’s top priority. Moreover, the Commission has indicated that enforcement of anti-discrimination laws depends upon people coming forward to file complaints. In addition to increased enforcement by the EEOC, the U.S. Supreme Court also has focused on retaliation claims, issuing a number of decisions making it easier for claimants alleging retaliation to prevail. Among them, the Court has lowered the bar of what a claimant must establish to win a retaliation claim and extended the scope of retaliation laws to grant protection to employees who merely respond to internal investigations of discrimination.

Most federal laws relating to workplace rights contain anti-retaliation provisions.  For example, retaliation against employees who oppose unlawful employment discrimination is expressly prohibited by Title VII of the Civil Rights Act of 1964, the Age Discrimination in Employment Act, and the Americans with Disabilities Act. In addition, the Fair Labor Standards Act prohibits retaliation against employees who file claims for unpaid wages, the Occupational Safety and Health Act prohibits reprisals against employees who exercise rights under the statute, and the Family and Medical Leave Act prohibits employers from interfering with an employee’s exercise of rights under the Act. Employees can also assert retaliation claims based upon their participation in workers’ compensation proceedings.

SOX also prohibits retaliation against an employee who provides information regarding any conduct which the em-  ployee reasonably (but not necessarily accurately) believes constitutes mail, wire, bank or securities fraud, or which violates any rule or regulation of the SEC or any provision of federal law relating to fraud against shareholders.  While the SOX prohibitions against retaliation clearly apply to companies listed on publicly traded stock exchanges, a recent decision of the Administrative Review Board of the U.S. Department of Labor expands whistleblower liability under SOX to private entities engaged in business with publicly traded companies (Kalkunte v. DVI Financial Services, Inc.). In this decision, a private company, which had contracted with a publicly traded employer, was found to be subject to SOX’s whistleblower provisions because the privately held company acted as an agent of the employer and was able to affect the claimant’s employment.
The most recent law to offer broad protection for whistleblowers is the ARRA, enacted by Congress as part of the economic stimulus package. These protections are designed for the benefit of anyone who furthers ARRA’s goal of preventing abuse and mismanagement of funds, safety and health violations and violations of law as related to activities of entities funded by stimulus monies.  Of note, this law specifically prohibits waivers and releases of rights and remedies in any agreement, including a pre-dispute arbitration agreement.

Lower the Risk of Retaliation Claims
The best way for employers to prepare for, and hopefully reduce, any potential em-ployee lawsuit is to create corporate responsibility standards and programs and effectively communicate such standards and programs to employees of all levels. Every company should have written policies and procedures which include a mission statement, acceptable standards of conduct, anti-harassment/discrimination policies, a code of ethics, and a corporate compliance program.
Employers should strive to create a working environment where employees are encouraged to alert management to potential problems and participate in investigations without fear of retaliation. Ensuring consistent administration of policies and responding appropriately and promptly once a complaint is made are the best ways to prevent retaliation claims. Management should reassure the employee lodging the complaint or participating in the investigation that he or she will suffer no retaliation as a result.

Joni Mason is a senior vice president of Executive Liability at Chartis Insurance (joni.mason@chartisinsurance.com).

If I could title this speech as I wished, I think I would title it: “Comprehensively Changing the Framework for Developing and Testing Principles of Corporate Governance in a Crisis-Driven, Politically Charged Atmosphere.”

Admittedly, it’s a mouthful. But it does set the backdrop for the potential change in litigation trends in this country. I think the impact of the hopefully resolving financial crisis on corporate governance is substantial. My first concern is a backdrop to this, which I will explain. Then I’ll talk about how we have been developing corporate governance in Delaware, and then I’ll tell you what I think the future holds, understanding, of course, [that] although the word “we” may slip in from time to time, I speak only for myself, not for my colleagues on the Delaware Supreme Court, in the Court of Chancery, on the Superior Court, or for that matter, the Justice of the Peace Courts in Delaware. I may be the only person in Delaware that has this view.

But I think we would make a serious mistake if we didn’t focus as we reshape corporate governance on the global competition for capital goods and services. It’s becoming apparent that it’s no longer necessary for international entrepreneurs to come to the United States for capital. There’s competition for capital, there’s competition for ideas, there’s competition in labor costs, which we simply cannot meet.

If we’re going to compete nationally and internationally, we have to focus on what some people have characterized as patient capital. We have to develop a framework in which investors can invest for the long term, and allow capital to produce what is typically American – innovative products that impact productivity, generate new ideas, and make our goods marketable across the world. Ultimately, this great engine that is the corporation is designed to enhance wealth for those who invest in it.

We should be careful when we reshape the framework of internal governance in a corporation, and not take our eye off the larger ball.

In today’s red-hot politicizing of corporate governance principles, we would do well, I think, to thoughtfully approach changes in those principles, changes that affect the relationship between the directors’ exercise of their authority, and their accountability for the way in which they exercise that authority.

In Delaware’s chartered corporations, the law empowers the directors to manage the corporation. But there are limits, and those limits are well described. They are described in two ways: first, by our enabling statute, for all its flexibility, it nevertheless creates a logical framework for making directors accountable for their actions. Some of the limits are shareholders’ concurrent power to amend bylaws, shareholders’ required votes to approve certain transactions, shareholders’ power to elect directors, and more importantly, to proscribe the process for electing directors, and effective August 1 in Delaware with a new proxy access law, proxy access with the right to propose a short slate.

I’ll get to that point in more detail later, but it bears emphasis to suggest that 14a-8 still blocks the now liberal proxy access that’s available under the Delaware law. HealthSouth is the first Delaware corporation, to my knowledge, to adopt a proxy access bylaw consistent with our August 1 statute. It goes nowhere unless the SEC allows proxy access.

I would say, to SEC Chairman [Mary] Schapiro and her colleagues, “Chairman Schapiro, tear down that wall.”

Give us the opportunity at the state level to shape proxy access as it suits each individual corporation and its investors. Don’t mandate proxy access in a way that may work for some but not for others. Our flexible enabling statute and our case law now gives a framework for corporations to shape their own form of proxy access. Let us experiment. Let us see how it works. Every corporation will not necessarily adopt the same bylaw. But our statutes liberally allow full reimbursement, if the corporation so chooses. There is no limitation on a holding period, and there’s no requirement of a certain percentage of shares. Each corporation can draft what suits it and its investors best.

This flexible enabling statute, along with developments on a case-by-case basis in Delaware law through common-law principles, primarily through fiduciary duty and the applications of the fiduciary duties of loyalty, with its subsets of candor, good faith, and due care are the hallmark of the way in which to shape corporate governance principles.

The common law shapes the law incrementally, case by case, based on precise, factual situations as those facts are found by one of our sitting Chancellors, in a court without  jury finding fact, and in a court that must produce a written opinion that justifies the facts that the judge finds, the principles of law that the judge believes applies, and an analysis of how those principles have been applied to those facts. It’s reviewable at only one level, and that’s the Delaware Supreme Court, and it’s rarely reviewed because of the quality of work that’s done–not because it’s not actually appealable, but because few parties who have litigated in our Court of Chancery  ultimately appeal.

We have proposed bills in Congress that are variously styled. They’re all hyperbolic. A bill of rights for shareholders–what American is opposed to a bill of rights?  A shareholder empowerment bill–who can be opposed to power to the people? Common law  methodology for shaping corporate governance has an advantage over regulations or statutory mandates. The advantage is, you can look at the real world situation as the dispute developed. You can see the shareholders’ pleaded complaint about the manner in which the directors acted or failed to act. You can apply the principles of fiduciary duty of loyalty and care to those facts, and develop the law in a way that gives a sense of predictability, consistency, and clarity.

If there’s anything business needs in this interesting time, it is a sense of predictability, consistency, and clarity in the law.

The question in Delaware’s legal system has always been: How can we shape the law to get the correct balance between directory authority and director accountability to the investor?  That balance, we continue to explore on the case-by-case, fact-intensive basis.

And we understand that this incremental way of shaping the law has a goal in mind beyond the resolution of an individual case. It is to properly rein in, as well as punish, malfeasance or misfeasance, or breach of fiduciary duty. But it’s also required to be shaped in a way that encourages the best possible people to serve as directors–a legal framework that encourages good people to serve as directors, thoughtful people, people who want to be informed of all the material facts before they cast an objective vote, people who are focused on the trust that’s been placed in them to act for others, and to enhance the corporate interest they serve.

The answer to most of our problems, if not all of them today, is to enhance the quality of directors, and focus them on their attention to their fiduciary duties.

As an aside, I commend to you an article that appeared in the last Business Lawyer, August 2009. It’s an article written by Lyman Johnson and Dennis Garvis. And it’s the kind of article that I enjoy, because it’s based on empirical evidence. It’s not a subjective judgment about where the law ought to go or why it should go there.

They did a survey of both outside counsel and in-house counsel to determine the extent to which counsel was advising both directors and officers of their fiduciary duties. And the results were somewhat startling to them, and to me.

They found, first, that not-for-profits, as opposed to for-profit corporations, were, on the whole, receiving advice about fiduciary duty more often and more thoroughly than for-profit companies. That was a surprising result to me.

More importantly, they found that while more directors were getting fiduciary duty assistance, instruction, [and] education, officers were not. In our Gantler v. Stephens case, we made clear last year what we’ve generally assumed in our law, and that is that fiduciary duties that apply to directors also apply to the officers of a Delaware corporation.

And there’s one huge caveat to note in that respect. For breach of duty of care in most chartered corporations, there is an exculpatory provision: 102(b)(7), we call it. Other states that have copied it call it something else in their code, obviously.

But basically, it says, in order to encourage directors to take a reasonable risk, that they would not be liable for a breach of the duty of care. They’re only liable for breaches–personally liable for breaches of the duties of loyalty, or a failure to carry out the duties of loyalty and care in good faith.

There is no such exculpation for officers who breach their duty of care. That’s why the instruction on fiduciary duty finding that Johnson and Garvis made–that fewer officers were receiving the advice than directors–is, to my mind, counterintuitive. It’s an obligation of directors, I think, to see to it that the full range of fiduciary duty, instruction, and assistance be made available to officers as well as directors, and it’s even more important that that happen sooner rather than later.

The other thing that we are concerned about in Delaware, and should be, is that our law is not applied in such a way that it chills responsible risk taking – that risk taking has been the engine that’s driven the corporation. It’s been the source of wealth enhancement for American corporations for almost 200 years.

We in Delaware have always soundly rejected the counterintuitive position that in order to achieve that proper balance or optimal balance between authority and accountability for directors, every business sector and every listed corporation must have the same internal governance structure.

Now, the politicizing. I tried to look up whether politicization was a word or not, but then I decided, since I can’t pronounce it, it really doesn’t matter whether it’s a word. But the politicizing of corporate governance today is remarkable.

We have bills in Congress that are variously styled. They’re all hyperbolic. A bill of rights for shareholders– what American is opposed to a bill of rights?  A shareholder empowerment bill– who can be opposed to power to the people?  And then finally, last week, tailed onto a 1,136-page bill designed to revamp the financial system, is a section called Strengthening Corporation Governance. Who in the room is opposed to strengthening corporate governance, empowering shareholders, or voting for a bill of rights?

No one, until you look at what actually might happen. These corporate governance principles, whether you agree with them individually or not, counterintuitively could not be better for everyone under every circumstance. Yet, all are mandated under each piece of this legislation. And the SEC empowered to bar listing your company on a national exchange if you do not comply with each of those corporate governance changes.

Now, I use the word change. I do not use the word reform. Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares–until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say, that all, much less each, of these proposed changes are truly reform. Reform implies to me, something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.

But when you think about it, it’s ironic that these measures are styled “shareholder democracy”, because each of them actually limits what shareholders can choose.

Under the state systems – at least, under ours – all of these listed principles of corporate governance can be adopted by a Delaware chartered corporation –, but they’re not mandated. Why?  Because we truly believe in a shareholder democracy. We believe there should be a buffet table of entrées from which you can choose what you prefer, and what principles you believe thoughtfully work in your corporation.

By mandating a set of new corporate governance principles that everyone must swallow, as if it were a pill for a disease you do not have, it seems to me, does not enhance majority voting in a shareholder democracy. The falsely described mandate limits shareholder choice.

Now, I recognize that in the wider world of things, Delaware’s role is small. Wags have said, Delaware is the mouse that roared. Well, to some extent, I don’t suggest to you that my ideas about corporate governance are better than anyone else’s. I’m perfectly convinced in my own mind that common sense tells me that many of these corporate governance principles may well help individual corporations. But common sense also tells me to mandate all of these principles for every corporation on a condition of being listed in our markets is counterproductive at best and foolish, at worst.

We will continue in Delaware to try to shape corporate governance on a case-by- case basis, and address, and look for and find hopefully that proper balance between director authority and director accountability. Where are we going with that? What are we seeing in litigation trends?

I think you can already detect, from what I’ve said in the last few minutes, I perceive as soon as plaintiffs’ lawyers focus on the fact that there’s no exculpation clause for directors, and focus on the fact that as of two years ago, you can get service of process over officers in Delaware corporations but who are not residents of Delaware, that we will see an emphasis in complaints of breach of fiduciary duty focused on officer action or inaction, as well as director action or inaction.

And why not? There’s no exculpation clause. There’s a more likely possibility, one might argue, for finding liability on the part of an officer for a breach of the duty of care, than a dismissal of a complaint that pleads nothing but a breach of duty of care, which can never result in damages, when it’s limited to directors who can rely on 102(b)7. So I would focus my attention, if I were in the boardroom today, on making sure that my officers understood that point, that my in-house counsel was giving them instruction on their fiduciary duties, and make sure that they were, as we used to say in the Army, trained up on the issues.

Corporate governance, and the development of corporate governance through our case law, is not a flavor-of-the-month process. We don’t react to what’s popular in the airwaves today. We are around for a long time. As judges in Delaware, some people may well say, too long. Somebody in the room whispered that, I’m sure. But we focus on these changes over time.

The very same case I mentioned, Gantler v. Stephens that focused on officer fiduciary duty, responsibility, and potential liability, also made another important point that cleared up Delaware law, which had been a bit murky over the years. And it’s important for future litigation. That’s the concept of shareholder ratification.

For many years, it was assumed that once there was a shareholder vote on an acquisition, that any breach of fiduciary duty that occurred before and related to that transaction was, by the shareholder vote on the merger itself, ratified. Therefore, any complaint of breach of fiduciary duty was subject to dismissal.

What this case clarified that, a shareholder vote that is obligated under the law, such as approval of an acquisition or a transaction from either end, will not absolve directors of earlier breaches of fiduciary duty, unless in the vote itself, the facts that would support an alleged breach of fiduciary duty are articulated separately for the shareholders. So the shareholders have a knowledgeable vote, not just on price, but focused also on any potential flaw in the process for achieving that price that could be alleged down the road. That “knowleagable vote” will result in ratification, and a dismissal of any suit for breach of fiduciary duty. It’s an important development in the law on which directors should focus.

As we continue to address issues of corporate governance, and recognize that we can’t separate ourselves from what’s going on in the world outside, I suggest to you that you will see continued development of the concept of good faith. There are two cases I’ll point out to you that I think will illustrate this in the Delaware case-by-case factual context.

Those two cases haven’t come to a conclusion, so nothing I say about them suggests to you, I hope, that I think they were decided correctly or incorrectly. But they do juxtapose exactly what’s going on in the risk-assessment world in Delaware.

The first is AIG, a case decided by one of our most brilliant Vice Chancellors [Leo Strine], who concluded, when the focus was on a motion to dismiss for failure to state the claim, that the facts as pleaded in that complaint, if ultimately proved, would establish that the conflicted board, which lacked independence, acted in such a way that was consistent with them being, and I quote, “a criminal organization,” close quote.

The focus of that case was on whether the plaintiff had adequately pleaded that the directors were not independent. They acted in their own interest, and not in the interest of the corporation itself, and diverted corporate assets to their own profit, rather than enhancing the wealth of the investors.

That case has survived a motion to dismiss. No one at this point knows whether the facts alleged will actually be proved or not. But that is scrutiny of director decision making, with language that in my 39 years of practice, I had never seen before. And it is that very same Vice Chancellor who will be making the ultimate findings of fact when that case goes to trial.

The second case is Citigroup. Citigroup is subject to a different pleading standard: the directors of Citigroup were sued for breach of fiduciary duty; and to summarize the complaint incompletely, it basically alleged that the directors of Citigroup had breached their fiduciary duty of loyalty and care, because they failed to see the warning signs that were developing on the horizon about derivatives and the subprime market. And by failing to predict in advance, they had made investments that they should otherwise have avoided. And the result of that breach of fiduciary duty, cost the investors in Citigroup millions of dollars.

Contrasted with AIG, the Citigroup complaint did not, because it could not, establish a lack of independence on the part of those directors. The Chancellor, who sat on that particular case, dismissed the complaint for breach of fiduciary duty, (you missed the subprime crisis), on the understanding that in the absence of a conscious disregard for their oversight responsibilities, the complaint had failed to plead a breach of fiduciary duty.

It’s important to focus on two things–the independence of the Citigroup directors, as opposed to the directors in AIG, and the burden on the complainant to establish either lack of independence or a conscious disregard of the fiduciary duty of “loyal oversight”.

Those two cases, I think, show that Delaware looks at each case based on the facts developed in the case, and the principles of corporate governance and director responsibility will flow from those incremental fact situations as they’re built over time.

There are final issues that I think we need to look forward to, ( on which we are yet to have cases, but it’s possible we might). So, one eye on the future is important.

What is the link between short termism and risk-assessment difficulties? There’s a wonderful article by William Bratton of Georgetown Law School and Michael Wachter of Penn Law School, examining that very issue. Would shareholder democracy make a difference in what some people think is a risk-assessment, crisis-driven financial system breakdown?

The conclusion in that article is, it would have made no difference, because it’s the very same shareholder community that has been demanding quick returns, rather than patient capital, that drove the risk assessment issues. It’s an article worth reading, whether you agree with its conclusion or not. Again, it’s an empirical study. It’s not based on subjective judgment about what the law ought to be.

I wonder what the role fiduciary duty will play after proxy access brings us the constituent director. Put aside collegiality in the boardroom, put aside long-term strategizing. Will constituent directors elected on a short slate focus on the fact that their fiduciary duties are owed to the entire corporation?  Or will they focus on the best interest of those that elected them?  Should they have different fiduciary duties, as a result, than other members of the board?

Right now, the law says no. We’ll see how the law develops.

As an increasing number of institutional investors sit back and don’t make independent decisions about how to vote, and allow themselves to be influenced by proxy advisors, will the law in the future, when 60 percent to 70 percent of shares are owned by institutional investors, and 60 percent or 70 percent of those are  passive institutional investors who take their advice from proxy advisors, will the law impose upon proxy advisors a fiduciary duty to be well informed before they advise, and to be loyal to the interest of the corporations in which those they advise are invested?

And finally, the 800-pound gorilla in the room: Will the federal government’s investments in nationally traded corporations result in a large equity stake held by the federal government? Will the federal government relies on provisions in its agreement with, for example, TARP recipients, and place federally nominated directors on the board? What will be the fiduciary duty owed by that director or those directors, and whose law will determine what that fiduciary duty should be?

In the three statutes that are proposed in Congress that I mentioned, several times the term “fiduciary duties” is mentioned. No jurisdiction is indicated [as to] who will enforce them; no comment is even made on how to define them.

We can assume the proposed bills mean common-law fiduciary duties, and state law has always defined them. But what if, as was argued in the case (before U.S. District Court Judge Jed S. Rakoff of the Southern District of New York) with former shareholders of Merrill Lynch suing the board of Merrill Lynch before it was merged into the Bank of America, future plaintiffs argue that “federal common law” decides the relative accountability and authority of directors of two Delaware-chartered corporations?

My view is , that to his credit, Judge Rakoff dismissed that argument, and made it as clear as we ever learned in law school, that there is no such thing as federal common law, and that Delaware state law applied–a correct decision not only on that point, but a correct decision as he interpreted and applied Delaware law.

But when terms like fiduciary duty are tossed into a statute without any thought about what do they mean, who and where will they be interpreted, and how will they affect those of you in the boardroom or those of you advising those in the boardroom?  It’s a mystery to me how any porposed bill can be passed responsibly before these potential unintended consequences are explored.

I hope, as I close, that what we will see is a thoughtful, considered, incremental development of the future of principles of corporate governance. There is a publicly traded corporation that says, quote, “Progress is our most important product.”

In Delaware, what progress and the development of principles of corporate governance means is, incremental change within a known factual context over time. It’s deliberate, thoughtful, predictable, consistent, and clear.

That’s the path we will continue to travel, and I can be sure of one thing absolutely. Delaware is too small to fail.

Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage. Indeed, the recent financial industry debacle is perhaps most surprising for its predictability in light of mundane realities accepted by social scientists of the center left and right.

It is well known that businesses aggressively seeking profit will tend to push right up against, and too often blow right through, the rules of the game as established by positive law. The more pressure business leaders are under to deliver high returns, the greater the danger that they will violate the law and shift costs to society generally, in the form of externalities. In that circumstance, if the rules of the game themselves are too loosely drawn to protect society adequately, businesses are free to engage in behavior that is socially costly without violating any legal obligations.

Moreover, the ability of any particular firm to resist imitating the overly risky, but law-compliant behavior of competitors will be compromised to the extent that managers face criticism or even removal for not keeping up with so-called industry leaders whose high, short-term returns have pleased a stock market filled with short-term investors looking for alpha.

Similarly, when power and influence over corporate activities is exerted by those whose primary interest is immediate gain and who have little or no intention to stay invested until the full costs of risky activity are borne — e.g., certain institutional investors who invest the money of others — corporate managers will have an incentive to be responsive to their demands.

When the marketplace presents opportunities for corporations to generate immediate gains through transactions structured so the profits are taken up front and the risks are perceived as minimal, corporations seeking to please a short-term-focused market are likely to seize them. Risks might be sold immediately to others, or theoretically contracted away through arrangements that look like insurance but don’t involve counterparties meeting the standards that apply to insurance companies. Or perhaps the risk is structured to kick in several years down the road.

Likewise, when institutional investors with strong voting clout encourage corporations to increase leverage in order to engage in stock buybacks, increase dividends or reap higher trading gains, responsive corporate boards may leave their corporations without adequate capital to weather tough times, times when many of the proponents of leverage are likely not to be around as stockholders anymore.

If an industry senses that the United States Treasury has its back in the event that risky activity threatens the industry’s health, its leaders may respond even more freely to these market incentives, because they view the industry as having a form of insurance from the taxpayers. When the industry and its leaders have also designed compensation systems that reward managers for generating short-term profits through risky activity — systems often implemented with the encouragement of investors desiring to give managers a strong incentive to pump up stock prices — managers who might otherwise be more focused on the long-term health of their employers are encouraged to go hellbent for leather for immediate gain, too.

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather then durably.

Distilled down, what is most critical is that robust prudential regulation protecting society from risky corporate activity abated, precisely when corporations faced increasingly strong pressures to engage in much riskier endeavors in order to generate short-term results. In the financial sector, this potent cocktail was chased by several governmental interventions to rescue the industry when its “innovative” activities threatened its health, a course of conduct that suggested that the financial industry could take risks other industries could not, because it had a de facto form of federal insurance.

There is, of course, much that is simplified about this description. But, it is in the main true. And it suggests that policy makers need to be mindful of the relationship between the power of the stock market to influence corporate policies and the strength of prudential regulation. Because even diversified long-term stockholders are likely to have an appetite for risk that exceeds what is socially prudent, there will always need to be strong rules of the game to govern industries whose failure poses socially unacceptable risks.

There is no escape from the fact that although corporations are sometimes seen as owned by those who own their equity and elect their boards, the actions of corporations affect a broader range of constituencies, including workers, creditors, consumers and society more generally; no sensible regulatory system can ignore that fact.

The difficulty is compounded when those who directly influence public corporations are not primarily end user investors focused on the long term and keenly worried about excessive risk — think workers who must invest in mutual funds for retirement — but far more likely to be financial intermediaries whose investment horizons are often less than a year.

Strong regulatory standards are indispensable, not simply for society, but also for end-user long-term investors themselves, who bear the long-term costs of corporate idiocy.

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

There is nothing new about the insight that the more incentives businesses have to generate short-term profits, the more likely it is that they will engage in excessively risky activity, especially if they believe that the risks will be borne by others if they come to fruition. We simply have another hard-learned lesson to point to about the costs of ignoring these realities.

In shaping the future, policy makers might therefore focus on two key objectives: re-instituting sound prudential regulation over financial institutions critical to the overall well-being of our capital markets and economy, and implementing policies that focus stockholders and boards on the objective of having corporations produce wealth in both sound, durable fashion.

Ideally, we want a system where corporate boards are highly accountable and responsive to their stockholders for the generation of sustainable profits. But for that policy objective to be achieved, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock prices. So long as many of the most influential and active investors continue to think short term, it is unrealistic to expect the corporate boards they elect to strike the proper balance between the pursuit of profits through risky endeavors and the prudent preservation of value.

Leo E. Strine Jr., vice chancellor of the Delaware Court of Chancery, is also the Austin Wakeman lecturer in law of Harvard Law School, an adjunct professor of law at the University of Pennsylvania and Vanderbilt law schools, and a Crown Fellow with the Aspen Institute.