Thursday, February 14, 2013

A New Remedy Against Directors Who Fail to Oversee the Corporation

Everyone agrees that directors play a vital role in monitoring the performance of modern corporations, including the establishment and enforcement of risk-taking standards. But can anyone seriously argue that in the mid-2000s the directors of Lehman Brothers, Bear Stearns, Citigroup, AIG or countless other financial companies maintained an attitude of “constructive skepticism,” as the Business Roundtable prescribes for directors, or adequately “monitor[ed] the management” of risk, which Martin Lipton, perhaps the preeminent corporate lawyer of our times, acknowledges to be one of the principal roles of corporate directors? The oversight failures of boards of directors are a silent monument to ineffective corporate governance, with severe negative effects on shareholders and the society at large.

Other than defeating a director’s bid for reelection in a proxy contest, which is next to impossible, the only legal tool available to shareholders seeking to hold directors personally responsible for their failures has been a suit for damages. Corporate law is a state-by-state issue, and states have made it extraordinarily difficult to hold a director financially responsible. The stated reasons are that directors should not be held responsible for simply errors in judgment and that if directors faced ruinous liability for failures of due care, no one would agree to be a director. 

Thus, for example, under the laws of the State of Delaware, where, because of its management-friendly and director-friendly corporate laws, most major corporations are incorporated, even a director who acts with “reckless indifference” or beyond “the bounds of reason” is free from personal financial liability. It takes “bad faith,” akin to intentional misconduct, to establish personal liability for directors in Delaware -- an extremely rare result, far rarer than incidents of director incompetence. And Delaware is not alone.

It should be obvious that, right or wrong, the current system cannot be counted on to provide a realistic incentive to directors to perform their monitoring functions in accordance with nominal standards.  A far more nuanced approach is necessary. The only arrow in the quiver need not be nuclear-tipped. What is needed is a judicial remedy to remove complacent, uninformed and ineffective directors from corporate boards.

Shareholders who wish to remove directors for inadequate performance should be permitted to sue the company to remove a director who fails in a material respect to perform his or her duties in a minimally acceptable manner. That minimal standard should be ordinary care, which is the standard that is said to govern directors now, rather than bad faith. A prevailing shareholder should be entitled to be paid reasonable attorneys’ fees and costs by the corporation, and fee levels should be set at a high enough level to make it worthwhile for qualified attorneys to take on the risk of losing the lawsuit and receiving only nominal fees. To avoid nuisance suits, the definition of “material” should be stated in terms of enabling major harm to occur because of the director’s actions or omissions.

It would be up to state legislatures to pass a law permitting such actions, but it might be unrealistic to expect any one legislature to do so, for fear that corporations incorporated in that state flee to a state with laxer standard. A possible solution would be for the New York Stock Exchange and the Nasdaq Stock Market to enact listing standards requiring corporations to insert in their by-laws a provision permitting shareholders to file such actions, or requiring corporations to be incorporated in states that permit such actions by law. If enacted by the state, the law could also bar the director from serving as a director of another company incorporated in the state. The federal securities laws already contain a provision permitting the entry of such orders, but this is limited to instances of securities law violations, and only upon the request of the SEC. A state-law based remedy is needed.

Facing the realistic possibility of being removed as a director would be a far more potent incentive to directors to perform their duties effectively than the microscopic possibility that they might be called on to pay damages. This is a realistic remedy that should improve director performance and therefore benefit corporate shareholders and the society alike.

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