Henry Keizer, global head of audit at KPMG International, sees a fundamental change taking place in how audit committees and boards work. “Oversight today is very different than it was a year or two ago,” he said. “We are witnessing a previously unseen velocity of change—whether it is business ownership models, valuations, or investor confidence levels. This mandates that audit committees and boards keep pace with the rate of change.”

To help directors tackle the significant oversight challenges ahead, KPMG’s Audit Committee Institute hosted the 5th Annual Audit Committee Issues Conference in Miami and Phoenix, co-sponsored by the National Association of Corporate Directors (NACD) and Weil, Gotshal & Manges. During a pre-conference roundtable discussion, the consensus was clear: 2009 will mark a critical inflection point for governance and oversight.

Audit committee agendas will be notable not only for what’s on them, but for how they will be carried out. Audit committees and boards are now approaching their responsibilities with greater intensity and vigilance—and with a sharp focus on accountability. (See related article,“More Focused, Intense Oversight Marks a New Era,” page 75.) They also recognize that being effective in their oversight role—particularly in a volatile and uncertain environment— requires a solid, real-time understanding of the business, the people who run it, and the board. In other words: It’s back to basics.

“You simply cannot leave your common sense at the door,” said Irvine O. Hockaday Jr., who serves on the boards of Crown Media Holdings, Estee Lauder, Ford Motor Co., and Sprint Nextel. “And that includes holding people accountable.”

Managing Through the Crisis

Economists and business leaders are painting an increasingly bleak picture of the economic outlook. They now expect the recession to be deeper and longer and have a greater impact on most companies than previously expected. While the banking crisis placed tremendous stress on many companies, that stress is now compounded by unprecedented uncertainty— about the U.S. and world economies, the markets, our financial system, and many of the fundamental assumptions underlying corporate strategies.

Helping to guide the company through the crisis and deal with the unprecedented uncertainty is now a top priority for boards and audit committees. By listening to the concerns, questions, and practices shared among top audit-committee members, how to manage becomes clearer. In fact, roundtable participants identified four general steps that audit committees (and in some cases the whole board) need to take to provide proper oversight in current conditions.

1. Monitor the impact of the economic crisis.

Timely and accurate forecast information is critical to obtaining a clear picture of where the company is heading. Identify possible red flags and closely monitor the company’s performance, including forecasted earnings and cash flow, and compliance with debt covenants. Be sure to test the forecasting models being used and develop worst-case scenarios.

“Management seems reluctant to embrace worstcase scenarios,” said one Issues Conference participant. “But there are data points that require rigorous analysis. If that’s the case, the board needs to say, ‘We don’t buy these assumptions. You need to come back to us with a different analysis.’”

Given increased consolidation in the financial industry, audit committees should consider the need to diversify sources of capital and establish new lines of credit. They also should expect to operate with tighter debt-to-equity ratios and more restrictions on the use of capital. Monitoring the impact of the crisis on the company’s ability to hedge against currency, interest rate, and commodity price volatility is also imperative. “Liquidity and alignment,” said Ellen J. Odoner, partner at Weil, Gotshal & Manges, “are clearly two of the greatest issues facing audit committees.”

2. Assess exposure to third parties affected by the economic crisis.

The impact on the company’s supply chain, key customers, and other third parties is a major area of exposure for most companies. Monitor the company’s exposure to all companies in financial distress; in addition to the supply chain and sales and distribution channels, key third-party dependencies include customers, banks, lenders, underwriters, insurers, guarantors, and counterparties. Identify critical dependencies, such as foreign suppliers and key customers. Understand, too, who in management is responsible for managing these risks and ensure that the company has a complete inventory of its third-party exposures.

3. Focus on internal controls—particularly as costs are cut.

As management seeks to reduce costs and implement layoffs, maintaining internal controls may pose a particular challenge. The control environment is very much on the minds of executives and audit committee members, said Mary Pat McCarthy, U.S. vice chair of KPMG LLP and executive director of KPMG’s Audit Committee Institute. “Consolidation and workforce reduction creates new worries about basic internal controls. When people are stressed and stretched they may cut corners and take greater risks,” McCarthy said. With the economic crisis placing tremendous pressure on management and employees, there may be an increased risk of fraud, so audit committee members should be prepared to inquire about the adequacy of fraud controls.

4. Understand the impact of the crisis on company financial statements, particularly the balance sheet.

How vulnerable is the company’s investment portfolio to changes in value in this environment? Have all exposures been identified and quantified? Consider how changes in financial markets affect the valuation of pension plan assets and funding requirements. Focus on possible asset impairments: Has management identified all assets that should be tested for possible impairment? Has management identified triggering events that may warrant impairment assessments of goodwill and other intangibles? If so, are the values that are determined realistic based on current market conditions— or were they based on historical assumptions? Question the assumptions that underlie management’s accounting judgments and estimates that might be impacted by the economic crisis. Help ensure that management’s disclosures (MD&A) accurately describe the impact of the financial crisis on the company, including the company’s liquidity risks, and the application of fair value.

“Clearly, 2009 is going to be a year of survival,” said Maureen J. Miskovic, executive vice president and chief risk officer of State Street Corp. “There will be tremendous pressure to swing for the fences—and we have to be alert to that.”

James N. Chapman, who sits on the boards of Chrysler, AerCap Holdings, Scottish Re Group, Tembec, and LNR Property, cited “embedded leverage, accountability, and tone at the top and throughout the organization” as critical areas of focus in the year ahead.

Prepare for a Crisis

More than half of the directors attending the Issues Conference said their audit committee had been involved in a crisis. The message: be prepared— ideally, with a written crisis-response plan. In developing a crisis-response plan, the audit committee should think about the range of issues that could trigger a crisis—from financial statement errors to compensation issues, fraud or misconduct, and going concern issues. Knowing who to involve— independent outside counsel, forensic accountants, auditors—as well as when (and what) to communicate to various stakeholders is critical to ensuring confidence in the process, and a thorough and timely resolution.

As one director who has been involved in major investigations emphasized, “getting it right the first time” is essential.

Keeping Up With Regulatory Changes

According to attorneys and governance professionals attending the conference, significant changes in the regulatory and governance environment are expected. On the regulatory front, Congress has already begun holding hearings on the financial crisis—trying to understand the cause and determining how to avoid such problems in the future. It’s expected that Congress will alter the underlying architecture of financial and market regulation, including possible regulation of credit rating agencies and hedge funds, as well as some modification of the structure and authority of regulatory agencies.

Conrad Hewitt, who in January stepped down as chief accountant for the Securities and Exchange Commission, pointed out that in 2005 the Commission began requiring some discussion of risk factors in company filings. Subsequently, in the proxy statements he reviewed, the discussions were generally bland and couched in more defensive tones, rather than as open communications with shareholders. Hewitt thinks that’s likely to change: “The disclosure of risk in the filings to investors should be more a communication than a defensive posture and this is fairly new…It’s an evolving situation and will continue to be.”

NACD president and CEO Kenneth Daly believes that while there’s currently “little or no energy” around efforts to create legislation on par with the Sarbanes-Oxley Act of 2002, there has been a shift of power to Capitol Hill. “There’s tremendous anger,” Daly said, “so the new Administration and Congress are reaching out to do something. They have all the cards now.”

On the governance front, institutional investors, regulators, and politicians have been scrutinizing the actions of boards, particularly in the context of the financial crisis, and exploring greater shareholder involvement in certain governance decisions, including executive compensation (say on pay), selection of director candidates (proxy access), and board leadership (independent board chair).

Holly J. Gregory, a partner with Weil, Gotshal & Manges, noted that together with more firms adopting majority voting, these initiatives reflect interest by some to pursue a more “shareholder-centric” model of oversight.

All of these issues make the job of the audit committee more difficult. And the challenges, as well as the potential legal liabilities, underscore the importance of adaptability in the face of extreme circumstances.

The ‘Risk Conversation’

There is clearly an intense focus on risk management today, given what’s happened in the financial markets and the economy. And while risk management has been on the radar—if not a priority—for most companies and boards over the past several years, many are asking whether we are really “moving the ball forward,” and if we need to be thinking about risk management in a different way.

During the conference, audit committee members took a different approach to the topic, and discussed the types of conversations that boards and audit committees (whoever oversees risk) are having—or perhaps should be having—about risk. Among other recommendations, these basic questions should be part of such conversations:

• Can management provide a holistic view of the company’s major risks—both on and off the balance sheet? What are the top five risks facing the business?

• How tolerant is management of risk, including low-probability yet “catastrophic” risks?

• How rigorously does management stress-test key risk assumptions?

• Are the board’s information sources sufficiently varied and objective?

• How does culture—including incentive compensation— impact the company’s risk profile?

In addition, it’s imperative that directors engage in a dynamic dialogue with the executive team to satisfy themselves that management can, and does, identify, assess, and manage risk effectively. This means having the right people at the table— the CEO, CFO, chief risk officer, general counsel, auditors, business-unit leaders responsible for managing the risks, and others. Effective oversight, for any committee, requires that directors understand, question, and test management’s core risk assumptions and perceptions, and are prepared to ask that vital “second question,” advises J. Thomas Presby, a director at American Eagle Outfitters, First Solar, Tiffany & Co., World Fuel Services, and Invesco. “As directors, we need to take control of what we do. It’s personal responsibility and you’re not limited to five days a year,” said Presby.

Sidney E. Harris, a director at TSYS and Ridgeworth Funds, concurred: “It’s clear that boards need to be digging deeper and asking harder questions.”

Focus on the models and the underlying assumptions— and here visualization can be helpful so that directors can see the impact of changing key underlying assumptions. Obtain input from third parties— auditors, outside counsel, consultants, and others— to test and validate management’s core risk assumptions and perceptions. Be particularly sensitive to the effect of compensation and incentives on the company’s strategy and risk culture.

It’s also imperative to understand the risk culture and constantly question different aspects of risk. “Enterprise risk is a continuous cycle,” noted Mary R. “Nina” Henderson, a director who serves on the boards of AXA Financial, Del Monte Foods, and Pactiv. “I don’t think that you should ever feel like you’ve got it finished. Done. It should be something that is constantly re-evaluated.”

“Directors need to consider whether a more dynamic interaction between directors and management is viewed as ‘too adversarial’ for the boardroom,” said Michael D. Schrage, a fellow at MIT Sloan School of Management Center for Digital Business. “If so, that may speak to the health, or lack of it, of the organization’s governance or boardroom culture.”

Consider the nature and flow of information and how risk is talked about within the company, and be wary of any reluctance, or “spinning,” when discussing risk. Periodically talk to the heads of the operating units who own and manage risk on a daily basis. To get a view of the risk culture from outside the boardroom, visit remote locations, “walk the halls,” and attend employee gatherings.

Laban P. Jackson Jr., an independent director and audit committee chair at JPMorgan Chase, recommends spending “informal time” with the CEO to get to know him or her outside of the boardroom. Accountability is also high on his priority list. Jackson strives to hold a weekly call with his CEO. “Remember who works for whom: Management works for me and I work for the woman in Kansas who depends on the 200 shares she has in our company,” he added.

Explore non-traditional risks such as long-term shifts in demographics, climate, or technology; the impact of organizational design on how the company manages risk; and the risks posed by the company’s culture, tone at the top, compensation structure, and reputation risk. “Management risk”—i.e., that management may be unable or unwilling to perform— should be a key area of focus, as should the risks posed by succession planning. Use a “mystery shopper” approach to probe for vulnerabilities by looking at the company from the outside in.

Discuss “black swan” risk scenarios and “darkside budgets”—those that we think can never happen— and play them out on paper. Said William R. Graber, director at the Mosaic Co., Archimedes, and Kaiser Permanente: “The improbable will happen more often than you think. Do management or audit committee teams really want to think about the Armageddon scenarios and what the risks are? Not really, but having been on both sides, it’s possible, and it’s productive to have an open dialogue with management.”

Also consider the risk of ineffective performance by the audit committee or full board. “The board should continually monitor its oversight processes,” said director and Northwestern University Prof. William J. White, who outlined a number of key elements of effective oversight. “This is not simply a once-a-year activity—it’s ongoing and dynamic.”

Before we question our system’s foundation, let’s review the historical record.

Advocates, including our most famous living free marketeer, former Fed chairman Alan Greenspan, celebrate Adam Smith as the founder of free market economics. But there is another, lesser-known side to the great Scottish thinker, which economist Herbert Stein wrote about: “He was not pure or doctrinaire about this idea. He viewed government intervention in the market with great skepticism…yet he was prepared to accept or propose qualifications to that policy in the specific cases where he judged that their net effect would be beneficial. He did not wear the Adam Smith necktie.”

Smith’s magnum opus, The Wealth of Nations, famously illustrated that the free market is guided to produce the right amount and variety of goods by a so-called “invisible hand.” But it is in his lesser-known work, The Theory of Moral Sentiments, where Smith proposes that it is the act of observing others that makes people aware of themselves and the morality of their own behavior.

In other words, capitalism requires a moral foundation to work its true magic. If we carelessly violate this boundary, we will indeed be subject to blame.

“Do unto others,” may not be the most sophisticated chapter in the Capitalist’s manifesto, but it makes for a very good beginning.

Boardroom Dynamo
Recently, I had the pleasure of interviewing Ira Millstein, senior partner of Weil, Gotshal & Manges, on the subject of how the boardroom needs to respond to the current crisis.

Ira’s world is the boardroom. His take on the current environment signals a sea change in the way the corporation and government will work together. While the immediate declaration of cooperation is a good thing, longer term we need to adapt a new set of governing principles or we may set into motion a system of corporate welfare and obeisance to legislated behavior that could permanently damage our ability to innovate and compete. Ira’s prescription: restore trust and accountability. Where to start? Compensation. How to begin? Separate the chief from the chair.

For more from Millstein on regulatory reform and other issues, see “A New Agenda.” We would do well to listen.

One Simple Way: Prevention is Preferable to a Cure
Overheard at the KPMG International Audit Committee Issues Conference from Henry Keizer, vice chair—audit of KPMG LLP:

“There is a real opportunity from my perspective for audit committee directors to set the right tone and be constructive in dealing directly and candidly with the CEO and the C-suite, so make sure you leverage it. Seize the challenging times by being a force for clarity and diligence in the boardroom. When the C-suite has their helmets on, they are down in the trenches and the team or the individuals may not have examined the issue that may now appear as only a distraction but later turns out to be critically important. Clarity, candor, and directness are the necessary ingredients to understanding and then influencing what goes on in the boardroom. So be confident…it’s enormously powerful. It’s all right to engage, even if it results in a tough board meeting, but one that was fair and robust and that no one walked out on. To me, if there’s one simple takeaway, it’s that—engage.”

With little fanfare, Delaware’s famed Court of Chancery dismissed a claim by Citigroup shareholders against current and former directors and officers that they had breached their fiduciary duty by failing to properly monitor and disclose risks arising from problems in the subprime lending market that resulted in massive losses.

It is the best news to come out of the crisis for board members who have had little to celebrate, say some lawyers. In his ruling, Chancery Court Chancellor William B. Chandler III made it clear he was not about to let the Delaware Courts become an instrument of the public’s emotional need to find a scapegoat for the financial mess. “Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future…” he wrote in his findings.

It is likely not the last word from the Delaware courts on who is or is not to blame for actions preceding and during the current financial crisis. But subsequent decisions can be expected to hew to Delaware’s sober, level-headed posture that has earned it its place far atop the corporate legal system for the last 200-plus years. Delaware lawyers and judges are adamant that the state will stay true to form and not engage in knee-jerk reactions to the nation’s financial crisis or potential threats of federal intrusion into corporate governance. “Even in this environment, we’re not in a panic,” says Delaware Supreme Court Chief Justice Myron T. Steele. “We’re not going to abandon fundamental principals that have served us well, or the methodology in applying these principles to keep the federal government at bay.” In fact, the Delaware courts have a history of keeping emotion and public passion from corrupting its decision-making process, say lawyers. Perhaps no decision demonstrated that fact better than the one handed down in 2005 by the Chancery Court in the case against the board of directors at Disney.

Delaware Rules

As Hollywood legend Sidney Poitier relaxed in the rotunda of the understated Georgian-style courthouse in southern Delaware, he could have been one of the out-of-town lawyers who frequently parachute into the state for corporate disputes in the Court of Chancery.

But Poitier, in his charcoal suit, was one of the star witnesses in a three-month trial that gripped the nation. The actor was in the rural community of Georgetown to be grilled about his actions as a director of The Walt Disney Co. He was on the hot seat, along with other directors, for awarding a kingly $140 million severance package to former Disney president Michael Ovitz, after Ovitz had served only slightly more than a year in the job.

As a director of Disney, Poitier was overseeing a Delaware company and, as such, was bound by the state’s corporate laws. The California-based entertainment giant is among the 63 percent of Fortune 500 companies and more than half of the companies on the New York Stock Exchange that have filed their certificates of incorporation in the state.

Delaware law governs the internal workings of these companies, including directors’ duties and liabilities. Because it is so dominant, Delaware state law is the de facto corporate law of the country. Over the years, court cases have drawn captains of industry to the state, from Texas oilman T. Boone Pickens, to Oracle founder Larry Ellison, to former Hewlett-Packard chief executive Carly Fiorina.

One-time FBI director Louis Freeh, a lawyer who heads a consulting firm in Wilmington that deals with corporate governance, ethics, and compliance matters, says in terms of jurisprudence, little Delaware is “leagues above its weight class…by every measure.”

“Delaware law is so powerful that I’ve been in Europe in the offices of general counsel and they’ve had a pile of Chancery Court opinions on their desk,” says Freeh, who also is a director of Bristol-Myers Squibb, a Delaware corporation.

Indeed, the state aspires to be the Tiffany & Co. of the incorporations business, says Steele. Its high-quality product is the state’s enabling corporation law that is nurtured, protected, and preserved by the state lawmakers. The state Division of Corporations, Court of Chancery, and Supreme Court are the service departments. “The state’s great advantage is its well-developed body of law dating to 1911 that is based on real cases focused on specific facts. Legislation divorced from specific facts that is applied across the board to every situation is unlikely to produce right or fair results,” says Steele.

Like Tiffany’s, Delaware works hard to protect its brand. Since 1899, when Delaware’s legislative body, the General Assembly, passed its management-friendly corporations act, leaders and lawyers have kept a watchful eye on the golden goose. Taxes and fees paid by corporations chartered for decades in the state have represented as much as a third of the state’s annual revenues. To stay on the cutting edge, Delaware has tweaked its constitution and corporate laws, and expanded the powers of Chancery Court.

Such seemingly opportunistic behavior has left Delaware open to a chorus of critics who, for years, have attacked the state as being the handmaiden of Big Business. They point to Delaware law, which gives directors broad powers to run the business and affairs of a corporation. In 1974, William Cary, a former chairman of the SEC, famously wrote that in its zeal to get revenues Delaware was leading a “race to the bottom” in corporate standards.

Delaware defenders counter that state lawmakers and courts always have done an exemplary job of weighing the needs of both management and shareholders to create stockholder wealth. “My personal sense is one of the reasons investors and managers trust Delaware is that everyone gets a fair shake and cases get decided on their merits,” says Vice Chancellor Leo Strine Jr., a judge in the Delaware Court of Chancery.

As the country grapples with its biggest financial crisis since the Great Depression, even some critics are saying Delaware has kept to the high road. “For a long time, Delaware was seen as very much tilted in favor of management in its law,” says William Clark, a partner at Drinker Biddle & Reath in Philadelphia, who wrote the 2007 shareholder- friendly statute for North Dakota. “But the courts have been moving to impose duties on directors that reflect the concerns of shareholders.”

As further evidence, Clark points to some proposed pro-shareholder amendments formulated by the state’s corporate lawyers that are expected to be introduced in the General Assembly in the coming weeks. They would give institutional shareholders more flexibility for proxy access.

One amendment would allow corporations to adopt bylaw provisions that would permit shareholders in an election of directors to have their nominees included in the corporation’s proxy materials. Another proposed amendment would allow companies to enact bylaw provisions to reimburse shareholders for proxy solicitation expenses. “That’s huge,” Clark says. “It’s a significant change to Delaware’s image of being pro-management.”

Building on the Past

Through a lucky twist of history for the state, Delaware managed to keep its ancient Court of Chancery–or court of equity–when other states were jettisoning them. Chancery Court, unlike a court of law, is based on principles of fairness. In medieval England, when the common law courts became bogged down with procedure, losing parties sometimes would appeal to the king, saying they should have won under rules of fairness. These appeals were turned over to the king’s lord chancellor.

The modern court is believed to have had its first major corporate litigation in 1911. Judges in the trial court try both fact and law. It does not handle criminal, tort, or family law cases. It is not bound by strict statutes of limitations. The court may issue temporary restraining orders, injunctions, or other forms of relief. Today, about 70 percent of the filings with the court are corporate or commercial law. Because the five judges spend about 80 percent of their time on these matters, corporate lawyers say they don’t have to spend time educating the judge. “In Delaware, you have a judge who knows the law as well as anyone,” says Stephen Radin, a partner at law firm Weil, Gotshal & Manges in New York. “That’s the beauty of Delaware–you’ve got a high level of judges.”

The court must be politically balanced and judges are appointed, not elected. When a vacancy occurs on the court, the state’s judicial nominating commission identifies qualified candidates and submits names to the governor. The governor makes the nomination, which must be approved by the state Senate.

The court develops its understanding of the boardroom by interacting with directors at director conferences and similar events, says Chandler. “These functions enable us to hear from actual directors about the concerns and problems they face, and it gives directors a chance to hear directly from the judges, in less formal settings, our views about the most problematic types of conduct by boards or the types of issues that we frequently see in court,” he says.

Corporate Fiduciaries

In the end, the state courts found that the Poitier and other Disney directors did not breach their duties of loyalty and care when they gave Ovitz a “breathtaking” golden parachute. While Chandler had harsh words for the Disney board, he ruled that Eisner and the board had made their mistakes in good faith, availing them of the protection of Delaware’s business-judgment rule. The rule shields companies, directors, and officers from liability as long as they uphold their duties of care and and loyalty.

The business judgment rule precludes the court from secondguessing decisions presumed to be made by informed, honest, and disinterested directors who are acting in the best interest of the company and its shareholders. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware and a director at HealthSouth, says the rule is paramount. “On any board, most decisions you make are subject to the business judgment rule. So directors are keenly aware of Delaware law. Delaware law plays a role in every boardroom.”

The business judgment rule can be rebutted if it can be proved the board violated one of its fiduciary duties through fraud, bad faith, or self-dealing, says Chandler. The fiduciary duties owed by directors of Delaware corporations are duties of due care and loyalty. The duty of good faith falls under the duty of loyalty, the Supreme Court found in 2006. The duty of loyalty mandates that directors unselfishly protect and act in the best interest of the corporation and its shareholders.

Under duty of care, officers and directors must conduct themselves as an ordinarily prudent person would in his own affairs, including considering all material information reasonably available, Chandler’s 174-page opinion on Disney reads. Chandler reaffirms that attention to the best interest of the company is conduct the court continues to expect from directors. “Judges of this court expect directors to act with complete fidelity to the corporation, mindful of their role as stewards of the corporate enterprise seeking, honestly and in good faith, always to advance its best interests,” he says. “The definition of a good director begins with one word: Loyalty. Actions that are rooted in good faith judgments, made with integrity and conscientiousness, will be respected by judges, and are the cornerstone of our deferential business judgment rule.”

Directors Under Scrutiny

The job of director has become increasing difficult and risky. As shareholders have watched their wealth vaporize in the stock market, some have predicted that angry shareholders will be looking for directors’ heads on platters. “Given that so many American workers now depend on equity investments for retirement, it’s only natural to expect independent directors to come under scrutiny when a major corporation suffers a serious setback,” says Strine.

One form of scrutiny is likely to be litigation over whether directors lived up to their fiduciary responsibility to monitor the corporation’s management, he says: “Current events suggest that there will be an increasing focus by investors and plaintiffs on how boards used their time and talent to ensure that their corporations had procedures in place to ensure legal compliance and manage fundamental risks.”

Some lawyers say they expect more lawsuits involving the socalled Caremark standard, which refers to a 1996 derivative litigation in which plaintiffs wanted to hold directors liable for an alleged failure to exercise sufficient oversight. In a derivative lawsuit, a shareholder plaintiff sues directors or management on behalf on the company. The landmark decision created an incentive for companies to have effective compliance programs in place.

“Caremark was a seminal case on the duty of oversight,” says A. Gilchrist Sparks III, a partner with Morris, Nichols, Arsht & Tunnell in Wilmington. “You don’t want directors to be so risk averse they’re not going to be entrepreneurial or that you’ll scare away directors from serving.”

In the same month that the Court of Chancery dismissed most of the claims against Citigroup, Strine allowed a derivative case brought by shareholder plaintiffs of American International Group against former chairman and chief executive Maurice R. Greenberg and three former inside directors to proceed. Plaintiffs want to recover money from AIG as a result of damages suffered when it was revealed that AIG’s financial statements overstated the value of the corporation by billions of dollars. The plaintiffs allege that Greenberg and his inner circle orchestrated widespread illegal misconduct.

“At this stage, a fair inference arises that Greenberg and the Inner Circle Defendants employed their expertise in illicit ways that ultimately resulted in billions of dollars of harm to AIG,” Strine writes in the opinion. “Moreover, the pleading of direct involvement by Greenberg and the Inner Circle Defendants in many of the specific alleged wrongs gives rise to a fair inference that the defendants knew that AIG’s internal controls and compliance efforts were inadequate.”

In January, in a separate case, the Delaware Supreme Court upheld a Chancery Court ruling which found plaintiffs had failed to show that directors of Viacom, including Chairman Sumner Redstone, had breached their duty of disclosure by making material misstatements, omissions, and misrepresentations in the prospectus, as well as their duties of loyalty and good faith. Duty of disclosure is not independent, but falls under duties of care and loyalty.

“Delaware law is so powerful that I’ve been in Europe in the offices of general counsel and they’ve had a pile of Chancery Court opinions on their desk.”                                                     – Louis Freeh, Bristol-Meyers Squibb

Chandler says he doesn’t expect an onslaught of litigation similar to the Citigroup case in which shareholders alleged a failure of board oversight in making certain investments. “Am I expecting an avalanche? I haven’t seen it so far,” says Chandler. What he does see is a potential for more deal-related lawsuits, such as the recent Rohm and Haas Co. v. Dow Chemical Co. In that case, Rohm & Haas asked the Chancery Court to force Dow to complete a $15.4 billion merger. The case was settled just as the trial was about to begin. Deals such as the Dow and Rohm & Haas merger, in which there are significant changes in the financial markets between the time the merger agreement is inked and the consummation of the transaction, could lead to more lawsuits, he says. “There’s money out there for these deals to get made, but then the economic downturn can make these deals look bad,” Chandler explains. Such lawsuits could take two forms. The target company might want the deal enforced. On the other hand, purchasers might pull a so-called MAC, seeking to back out because of a material adverse business or economic change involving the company to be acquired.

Chandler says there could also be more litigation involving executive pay, a hot-button shareholder issue today. “I can see increasing litigation over some exotic forms of poison pills,” he adds.

Constant Attention

While Delaware’s lawmaking process leans toward the judge-made law in Chancery Court and the Supreme Court, the General Assembly also has a role in keeping the laws flexible and responsive, lawyers say. Consider the current amendments to the corporate statute proposed by the Delaware State Bar Association. The proxy reimbursement amendment is in response to a 2008 Delaware Supreme Court decision in CA Inc. v. AFSCME Employees Pension Plan, which involved reimbursement for reasonable expenses in connection with nominating candidates in a contested election of directors.

Another amendment deals with the 2008 Chancery Court ruling Schoon v. Troy. In that case, Vice Chancellor Stephen P. Lamb ruled a former director was not entitled to advancement of legal fees and expenses in connection with breach of fiduciary duty claims under an amended bylaw. The proposed amendment to the DGCL says that the right to indemnification or advancement provided in the certificate of incorporation or a bylaw can’t be eliminated or impaired after an act or omission that becomes the subject of an investigative action, lawsuit, or proceeding. However, the right can be eliminated retroactively if the indemnification provision at the time of the act authorizes it.

There is also an amendment that proposes to expand the power of Chancery Court. Under Delaware law, only shareholders can remove directors. The amendment would permit the court to remove directors in limited emergency circumstances following conviction of a felony or a judgment for a breach of fiduciary duty.

Elson, Steele, and others have been concerned that measures related to the federal bailout and stimulus bill encroach on governance matters that have historically been handled by the state. But Steele isn’t worried. “We’re still the Tabasco of spice, the Coca-Cola of soft drinks,” he says.

Delaware’s Top Law Firms

Though Delaware is thick with lawyers of all varieties (about 18 per 10,000 residents, third in the nation behind New York and Washington D.C.), it is the absolute Mecca of business law, home to almost 100 corporate law firm offices.

For corporate legal counsel and representation of all types— including audit, mergers and acquisitions, intellectual property, corporate governance, litigation, and bankruptcy—Delaware could be a one-stop shop.

Here are some of its biggest and bestknown firms:

As Delaware’s largest law firm, Richards, Layton & Finger has built its staff of more than 150 attorneys through over a century of providing quality legal services in six different practices to a number of influential clients. Today, the firm’s top attorneys include Robert J. Krapf and Gregory P. Williams.

Young Conaway Stargatt & Taylor has worked with clients ranging from international corporations to small businesses and individuals in need of legal advice and assistance. Its legal staff of 112 has managed many groundbreaking cases, helping to shape the state of Delaware law for more than half a century. Attorneys Bruce L. Silverstein and Robert S. Brady have distinguished themselves in Delaware corporate law.

With almost 100 attorneys, Morris, Nichols, Arsht & Tunnell guides Fortune 500 companies and not-for-profits alike through the intricate pathways of corporate law. Morris Nichols attorneys drafted the Financial Center Development Act of 1981, a piece of legislation that allowed national banks and credit card companies to start work in Delaware. Top governance lawyers at Morris Nichols include A. Gilchrist Sparks III, who was recently named Delaware Lawyer of the Year in corporate law by the Best Lawyers in America Guide.

Having opened its doors in 1826, Potter Anderson & Corroon is Delaware’s oldest law firm and one of its stalwarts. Two of its attorneys, Donald J. Wolfe Jr. and Michael A. Pittenger, authored “Corporate and Commercial Practice in the Delaware Court of Chancery,” the first-ever treatise on the Chancery Court.

M&A powerhouse Skadden, Arps, Slate, Meagher & Flom includes a Wilmington office in its global empire, home to approximately 60 attorneys. Though M&A is a primary focus, the office also works in the practice areas of litigation, restructuring, and class-action litigation. With four offices spread throughout Delaware, Morris James and its staff of 54 attorneys work with clients of all sizes across a variety of practice categories. Founded in 1931 as a two-man practice, the firm has evolved through the years to become a crucial player in Delaware law.

Ashby & Geddes is a Wilmington-based firm best known for its expertise in litigation; its nearly 30 attorneys also conduct a corporate reorganization and insolvency practice. It has earned the highest-possible rating of “AV” from Martindale-Hubbell, the country’s leading legal ratings agency.

The credit crisis, according to authors and Weil counselors Ira M. Millstein, Holly J. Gregory and Rebecca C. Grapsas, “has heightened focus on the importance of risk management at all corporations and has encouraged a fresh look at the role of the board in risk oversight. Although the manner in which a board fulfills its risk oversight responsibilities is a matter of business judgment, directors should bear in mind that conduct will be judged by investors, regulators, the media and others with the benefit of 20-20 hindsight.”

Included in the ten advisory points: tailoring individual corporate governance structures to the specific needs of the company in question; the possible advantages of independent directors; disclosure process review; and healthy shareholder communication.

The report is entitled “Ten Area for Enhanced Board Focus in 2009—Spotlight on Risk Oversight.” It can be found here.

Richard S. Fuld Jr., CEO of bankrupt Lehman Brothers, will step down without any severance or bonus, according to The Associated Press.

Last year, Fuld was paid $34.4 million. He agreed to stay on as CEO while lawyers and other professionals dispersed Lehman’s assets to pay creditors after the investment bank went bust Sept. 15 in the largest bankruptcy case in U.S. history.

“His employment will end at the end of the year,” Lehman’s lead bankruptcy lawyer, Harvey Miller of Weil, Gotshal & Manges, told Bloomberg News during a break at a hearing in Federal Bankruptcy Court in Manhattan. “He is being terminated. He will receive no severance or bonuses.”

A spokesperson said that Fuld offered to provide the transition cooperation without any severance or claim to other bonus payments at the end of his employment. Fuld will continue to be chairman of Lehman’s board and will stay on to help with the bankruptcy through the end of the year.

Fuld faced growing pressure to step down as critics accused him of contributing to the fall of the nation’s fourth-largest investment bank.

“These principles do not in any way undermine or negate further discussion, debate, and development of governance practices. We hope that the agreed principles will encourage boards, managers, and shareholders to eschew a check-the-box approach in favor of thoughtful governance, tailored by boards themselves to their particular circumstances and embraced by all stakeholders,” wrote NACD president and CEO Kenneth Daly in an introductory letter.

The principles, drafted pro bono by Ira Millstein and Holly Gregory and colleagues at Weil, Gotshal & Manges, are as follows:

1. Board responsibility for governance: Governance structures and practices should be designed by the board to position the board to fulfill its duties effectively and efficiently.

2. Corporate governance transparency: Governance structures and practices should be transparent— and transparency is more important than strictly following any particular set of best practice recommendations.

3. Director competency and commitment: Governance structures and practices should be designed to ensure the competency and commitment of directors.

4. Board accountability and objectivity: Governance structures and practices should be designed to ensure the accountability of the board to shareholders and the objectivity of board decisions.

5. Independent board leadership: Governance structures and practices should be designed to provide some form of leadership for the board distinct from management.

6. Integrity, ethics and responsibility: Governance structures and practices should be designed to promote an appropriate corporate culture of integrity, ethics, and corporate social responsibility.

7. Attention to information, agenda and strategy: Governance structures and practices should be designed to support the board in determining its own priorities, resultant agenda, and information needs and to assist the board in focusing on strategy (and associated risks).

8. Protection against board entrenchment: Governance structures and practices should encourage the board to refresh itself.

9. Shareholder input in director selection: Governance structures and practices should be designed to encourage meaningful shareholder involvement in the selection of directors.

10. Shareholder communications: Governance structures and practices should be designed to encourage communication with shareholders.

For a PDF of the NACD document, click here.

“This is the first year we are recognizing the next generation of corporate governance leaders,” said Ira M. Millstein, senior associate dean for corporate governance at the Yale School of Management and an architect of corporate governance recognized last fall by Directorship magazine in its Directorship 100, an inaugural list of the most influential players in corporate governance. “Every one of this year’s 56 recipients is a rising star in his or her own right. I’m honored to be able to recognize them in this way,” Millstein said.

The rising stars of corporate governance are:

• Sanaa Abouzaid, corporate governance officer, International Finance Corp.
• Tagbo Agbazue, project coordinator, African Institute of Corporate Citizenship
• Steve Alogna, senior manager, corporate governance services, Deloitte & Touche
• Annalisa Barrett, senior research associate, The Corporate Library
• Rachel Beck, business columnist, Associated Press
• Sagarika Chatterjee, senior analyst, F&C Investments (London)
• Warren Chen, managing director, M&A and quantitative analyst, Glass, Lewis & Co.
• Patrick Daniels, partner, Coughlin Stoia Geller Rudman & Robbins
• Andy Eggers, president, Proxy Democracy
• Maureen Errity, firm director, Center for Corporate Governance, Deloitte & Touche
• Todd Fernandez, senior research analyst, Glass, Lewis & Co.
• Jun Frank, senior research analyst (Asia), Glass, Lewis & Co. 
• Nichol Garzon-Mitchell, deputy general counsel, Glass, Lewis & Co.
• Rebecca Grapsas, associate, corporate department, Weil, Gotshal & Manges
• Dan Heitger, associate professor of accounting and co-director of the Center for Business Excellence, Miami University
• Alexandra Higgins, research associate, The Corporate Library
• Quinton Huckeby, analyst, Proxy Governance
• Catherine Jackson, manager, corporate governance and proxy voting, Ontario Teachers’ Pension Plan
• Fianna Jesover, senior policy manager, corporate governance, Organisation for Economic Co-operation and Development
• Bess Joffe, associate director, corporate governance, Hermes Equity Ownership Services
• Jan-Friedrich Kallmorgen, director, Europaische Investorenshutzvereinigung
• John Keenan, senior analyst, pension and benefits policy, AFSCME
• Matt Kelly, editor-in-chief, Compliance Week
• Dan Konigsburg, director of corporate governance, Standard & Poor’s Equity Research
• Claudia Kruse, vice president European Environmental, Social and Governance Research, JPMorgan (London)
• Rakhi Kumar, corporate governance policy analyst, The Institute of International Finance
• Laura Lonsdale, ombudsman, Tyco International
• Allie Monaco, vice president of research, Proxy Governance
• Michael McCauley, senior corporate governance officer, Florida State Board of Administration
• Mary Jane McQuillen, director, socially aware investment, ClearBridge Advisors
• Jason Mefford, vice president, business process assurance, Ventura Foods
• Jeffrey B. Miller, chief compliance officer and counsel, Synthes
• Matt Orsagh, CFA, CIPM, senior policy analyst, CFA Institute Centre for Financial Market Integrity
• Rajesh Parthasarathy, president and CEO, MENTISoftware
• Dan Pedrotty, director of the office of investment, AFL-CIO
• Christian Plath, assistant vice president, corporate governance, Moody’s Investor Services
• Michael Pryce-Jones, senior analyst, Proxy Governance
• Naheeda Rashid, corporate governance and engagement, Hermes Equity Ownership Services
• Tracey Rembert, senior governance analyst, Service Employees International Union
• Joel Rogers, director of consulting services, RedHawk Communications
• Nicole Sandford, partner, board advisory services practice, Deloitte & Touche
• Hege Sjo, European Governance and Engagement, Hermes Equity Ownership Services
• Phillip Spathis, executive officer, governance and engagement, Australian Council of Superannuation Investors
• Alan Srulowitz, vice president, internal controls, CA, Inc.
• Tracy Stewart , corporate governance manager, Florida State Board of Administration
• Scott Stokes, deputy research director, GovernanceMetrics International
• Daniel Summerfield, co-head of responsibleinvestment, Universities Superannuation Scheme
• José Tabuena, vice president integrity and compliance/corporate secretary, MedicalEdge Healthcare Group
• Peter Taylor, head of corporate governance, Aberdeen Asset Management
• Meagan Thompson-Mann, president, MCTM Governance
• Carla Topino, senior research analyst (Europe), Glass, Lewis & Co.
• Dan Wadsworth, senior director of corporate client group, NASDAQ Board Tools
• Kerrie Waring, COO, International Corporate Governance Network
• Mark Watson, partner, Tapestry Networks
• Brittany Wedereit, vice president, proxy research, Glass, Lewis & Co.
• Clarence Yang, associate, Barclays Global Investors

The selected stars were recognized earlier this week during a reception at the 2008 Yale Governance Forum hosted by the Millstein Center.

Harry Pearce, chairman of Nortel Networks, is the founding chair of the forum. Spencer Stuart, the director and executive search consulting firm, will co-sponsor the event aimed at allowing U.S. and Canadian chairmen to share experiences, test opportunities for collective action on market issues, and form the core of a global network of chairmen organizations.

An estimated 35 percent of S&P 500 corporations have moved to implement a separate chairman rather than combining the job with that of CEO. The Millstein Center predicts that upswing will continue. Washington Mutual and Citigroup recently elected to separate the two positions. Last week, shareholders at ExxonMobil voted strongly in favor of adopting the independent chair model.

Pearce said the inaugural forum will consider endorsing policy guidance on the role of an independent chair in North America. The statement is being drafted by Pearce and Ira M. Millstein, senior associate dean for corporate governance at the Yale School of Management and senior partner at Weil, Gotshal & Manges.

The Conference of Fund Leaders is a permanent body dedicated to peer collaboration among independent chairmen and lead directors of mutual funds. Stephen Davis, the project director, is also the editor of Global Proxy Watch, which is owned by Directorship.

Executives at the firm have complained that a whisper campaign started by short sellers contributed to the flight of capital and forced the company to turn so quickly to JP Morgan Chase and the Federal Reserve Bank for a bailout.

Lehman Brothers also claims to be a victim of a vicious “short-and-distort scheme.” The shorts played so nasty that Lehman CFO Erin Callan went on CNBC and complained to “Closing Bell” anchor Maria Bartiromo that the SEC needed to investigate the abusive tactics of short sellers. (Perhaps the best revenge was that once Lehman secured additional funding, its stock rallied, shaking out many of the shorts in a classic squeeze.)

Securities and Exchange Commission Chairman Christopher Cox claims to be on the case. Testifying in April before the Senate Banking Committee, Cox said: “The SEC very aggressively pursues insider trading, market manipulation, and the kinds of illegal naked short-selling that has been very publicly alleged in [the Bear Stearns] case.”

Just weeks later, the SEC charged Wall Street trader Paul Berliner with fraud and market manipulation for allegedly spreading false rumors about The Blackstone Group’s buyout of Alliance Data Systems (ADS) after selling the company short. The SEC alleged that Berliner circulated false rumors through instant messages picked up by the media, spurring such heavy activity that the New York Stock Exchange temporarily halted trading of ADS stock. (See timeline at right.)

“The increased awareness of possible ’short and distort’ practices, the strong statements by securities regulators, and the number of investigations currently pending suggest that an increase in regulatory enforcement and litigation in this area is likely,” a client memo issued by Weil, Gotshal & Manges said. Berliner settled the charges by agreeing to pay $156,000.

Executives at the investment bank have complained that the flight of capital was part of the reason it turned to JPMorgan Chase & Co. and the Federal Reserve Bank for financing and to stave off its outright collapse.

In a briefing to its clients last week, Weil, Gotshal & Manges forewarns that such “short and distort” conduct is at the very least being taken seriously by regulators here in the U.S. and the U.K. in anticipation of criminal indictments and possibly new regulations.

Testifying last week before the Senate Banking Committee, Securities and Exchange Commission Chairman Christopher Cox said that the SEC “takes very seriously its responsibility to investigate allegations [concerning the spreading of rumors designed to affect the market value of an issuer’s equity securities], and there have been ample allegations made.”

Similarly, in a joint news release issued late last month by the Financial Industry Regulatory Authority (FINRA), NYSE Regulation, and participants of the Options Regulatory Surveillance Authority said that “[m]arket participants should be especially aware that intentionally spreading false rumors or engaging in collusive activity to impact the financial condition of an issuer will not be tolerated and will be vigorously and aggressively investigated.”

Moreover, the U.K.’s Financial Services Authority (FSA) issued a warning stating it would “not tolerate market participants taking advantage of the current market conditions to commit abuse by spreading false rumors and dealing on the back of them.”

“Short and distort” conduct was also a topic at the annual Compliance and Legal Seminar of the Securities Industry and Financial Markets Association were enforcement officials from the SEC, FINRA and the FSA indicated that they are investigating this type of conduct.

Spreading false rumors in order to induce others to trade in a company’s securities may constitute market manipulation under Sections 9 and 10(b) of the Securities Exchange Act of 1934. On the Self-Regulatory Organization front, NYSE Rule 435(5) and its FINRA corollary prohibit member firms from circulating “in any manner rumors of a sensational character which might reasonably be expected to affect market conditions on the Exchange,” the Weil, Gotshal memo pointed out. Criminal charges were brought against the Toronto-based insurance conglomerate Fairfax Financial Holdings Ltd. against S.A.C. Capital Management and other defendants, alleging a “massive and fraudulent disinformation campaign” coupled with short-selling.

“The increased awareness of possible ’short and distort’ practices, the strong statements by securities regulators and the number of investigations currently pending suggest that an increase in regulatory enforcement and litigation in this area is likely,” the law firm memo concluded.