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From “Be ambitious to be quiet, engaged in your own affairs, and working with your hands” (2013)

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  1. Chapter 16 Public Shareholder Activism From “Be ambitious to be quiet, engaged in your own affairs, and working with your hands” (2013)

  2. Module VII – Fiduciary Duties Chapter 19Board Oversight Bar exam Corporate practice Law profession Director functions Who can be on board? What is expected of directors? “Std of conduct” vs. “std of liability” Board supervision - CHC Pritchard case Causation? Board supervision - PHC Caremark case Internal controls Corporate law Sarbanes-Oxley / Dodd-Frank Oversight and duty of care Stone v. Ritter: legal compliance programs In re Citigroup: business risk assessment Citizen of world Chapter 19 Board Oversight

  3. Director’s functions … Chapter 19 Board Oversight

  4. Join the board? William Charles New director Board Pritchard & Baird Corp. Premium Payers Reinsurance Companies Chapter 19 Board Oversight

  5. Qualifications? • Natural person • Need not own stock • No special expertise • “should” become familiar with business • “financial expert” only on PHC audit committee • Functions? • Attend mtgs / be informed • Set corp policy / strategies   • Hire / fire / pay executives   • Monitor (business / illegality / misconduct)  • Inquire /object when necessary • Manage business in crisis MBCA § 8.30 Standards of Conduct for Directors (a) Each director, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation. (b) The directors, when becoming informed in connection with board’s decision-making or oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances. Chapter 19 Board Oversight

  6. What should director do when suspicious? Chapter 19 Board Oversight

  7. Statement of financial condition Working Net Capital Shareholders‘ Brokerage Deficit Loans Income ___________ _____________ ___________ 1970 $389,022 $509,941 $807,229 1971 not available not available not available 1972 $1,684,289 $1,825,911 $1,546,263 1973 $3,506,460 $3,700,542 $1,736,349 1974 $6,939,007 $7,080,629 $ 876,182 1975 $10,176,419 $10,298,039 $ 551,598 Your duties? Your options? Resign? Chapter 19 Board Oversight

  8. MBCA § 8.24  Quorum and voting. (d) A director who is present at a meeting of the board of directors ... when corporate action is taken is deemed to have assented to the action taken unless: (1) He objects at the beginning of the meeting ... to holding it ... (2) His dissent or abstention from the action taken is entered in the minutes of the meeting; or (3) He files written notice of his dissent or abstention with the presiding officer of the meeting before its adjournment or with the corporation immediately after adjournment ... The right of dissent or abstention is not available to a director who votes in favor of the action taken. Chapter 19 Board Oversight

  9. Directors & Boards e-Briefing (April 2006) How would you (as shareholder) respond to a director resignation – specifically, the kind of “noisy exit” made by a board member of XM Satellite Radio. The survey showed: • Buy More on a Market Drop: 4.8% • Sell Immediately: 38.1% • Hold -- Wait and See: 38.1% • Other: 19.0% Chapter 19 Board Oversight

  10. Directors & Boards e-Briefing (April 2006) How would you (as shareholder) respond to a director resignation – specifically, the kind of “noisy exit” made by a board member of XM Satellite Radio. The survey showed: • Buy More on a Market Drop: 4.8% • Sell Immediately: 38.1% • Hold -- Wait and See: 38.1% • Other (depends on who): 19.0% Chapter 19 Board Oversight

  11. Liability of directorsfor lack of supervision … Chapter 19 Board Oversight

  12. Aspirations vs. reality “A standard of conduct states how you should play a role. A standard of review states whether a court should impose liability.” “In the real world, standards of review in corporate law pervasively diverge from standards of conduct.” Professor Mel Eisenberg Chapter 19 Board Oversight

  13. When is “absent” director liable?Francis v. United Jersey Bank By the way, who is Francis and why is United Jersey Bank in the case? Chapter 19 Board Oversight

  14. NJ Supreme Court: "Her neglect of duty contributed to the climate of corruption; her failure to act contributed to the continuation of that corruption.  Consequently, her conduct was a substantial factor contributing to the loss.   "Sometimes ... a director may have a duty to take reasonable means to prevent illegal conduct by co-directors; in an appropriate case, this may include threat of suit.” Francis v. United Jersey Bank (NJ 1981) Chapter 19 Board Oversight

  15. Malfeasance vs. misfeasance … Chapter 19 Board Oversight

  16. William Jr. and Charles, rather than evil, are just witless -- a case of "good genes gone bad."  They make foolish decisions and run the business into the ground through sheer incompetence. Mrs. Pritchard, absent and intoxicated, fails in her directorial responsibilities. Would witless William and Charles be liable for their lack of care?  Is Mrs Prtichard liable for her absence? What could she have done? Hypothetical  Chapter 19 Board Oversight

  17. “True, he was not very suited to the job, but I cannot hold him on that account. After all it is the same corporation that chose him that now seeks to charge him. “Must a director guarantee that his judgment is good?“ Barnes v. Andrews (2d Cir 1924) Chapter 19 Board Oversight

  18. Board monitoring of illegality When must directors react? Internal controls required? What does Sarbanes-Oxley do? Chapter 19 Board Oversight

  19. Chapter 19 Board Oversight

  20. Allis Chalmers An electrical equipment manufacturer, is a wondrous multi-tiered bureaucracy. Its employees, under pressure to make profits, conspire to fix prices. You are a director of Allis-Chalmers. What must you do to ensure legal compliance? Caremark A health-care provider, engages in referral kickbacks. This is illegal under Medicare and Medicaid. Regulators and private payors sue, and Caremark agrees to compliance measures and pays $250 million. You are a Caremark director. Are you liable for not having internal controls? Delaware law Shareholders Board X Chapter 19 Board Oversight

  21. Allis-Chalmers (Del 1963): … that in 1937 the company had consented to the entry of [antitrust] decrees ... did not put the Board on notice There is no duty upon the directors to install and operate a corporate system of espionage … Only if he has “recklessly reposed confidence in an obviously untrustworthy employee. Or has ignored … obvious danger signals” Caremark (Del Ch 1996): “... corporate boards may satisfy their obligation to be reasonably informed concerning the corporation [by] assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and the board itself timely, accurate information sufficient to allow management and the board .... to reach informed judgment concerning both the corporation’s compliance with law and its business performance. Delaware law Chapter 19 Board Oversight

  22. “Plaintiffs would have to show Either (1) that the directors knew or (2) should have known that violations of law were occurring [sustained and systematic failure] and in either event,  (3) the directors took no steps in good faith effort to prevent or remedy that situation  [and] (4) [defendants do not establish affirmative defense] that such failure [did not] proximately result in the losses complained of … Chapter 19 Board Oversight

  23. Section 404: Management Assessment Of Internal Controls. Requires each annual report of an issuer to contain an "internal control report", which shall: (1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Chapter 19 Board Oversight

  24. Good faith and oversight … Illegal conduct: Stone v. Ritter Business risk: In re Citigroup Chapter 19 Board Oversight

  25. Stone v. Ritter (Del. 2006) Bank Secrecy Act: complicity and failure to notice Ponzi scheme - $50 million fine Issue: Demand futility? How likely that directors liable for oversight of BSA compliance program? Holding: approving and applying Caremark, no “sustained or systematic” oversight failure since “reasonable” compliance program existed Chapter 19 Board Oversight

  26. In re Citigroup (Del. Ch. 2009) Financial risk assessment: failure of directors to notice company’s subprime exposure - $55 billion in potential losses Issue: Demand futility? How likely that directors liable for not appreciating subprime risk? Holding: Demand required. Court applies Caremark to business risks (compared to compliance risk), but says BJR teaches against hindsight bias and for informed risk-taking / ARM Committee existed Meredith Whitney 25 Most Powerful on WS Chapter 19 Board Oversight

  27. Pop quiz – MBCA S 8.31 Chapter 19 Board Oversight

  28. MBCA § 8.31 – stds of liability No director personal liability unless: Challenged conduct not in good faith Decision not reasonably believed best interests Decision not informed in circumstances D’s lack of objectivity due to relationship / domination D’s sustained failure of director to be informed D’s receipt of financial benefit for which not entitled Case facts EBay litigation (inside Ds pocket IPO allocations) Francis v United Jersey Bank (D absent and inattentive) Shlensky v. Wrigley (Ds unreas on day-only baseball) Caremark (Ds knowingly accept/ indifferent to illegality) Smith v Van Gorkom (Ds fail to be informed about merger) Aronson v Lewis (Ds dominated by major Sh/CEO) Answers: Chapter 19 Board Oversight

  29. Trends in corporate governance … Chapter 19 Board Oversight

  30. 10 trends that will shape governance landscape (2006): 1. Majority voting will become the norm, replacing the plurality vote standard 2. Executive compensation will be brought into line: enhanced SEC disclosure, advisory shareholder votes,, and recognition of internal pay equity. 3. Separating the roles of chairman and CEO 4. The model of the imperial, celebrity CEO will be replaced by the stewardship model 5. Sustainability and corporate social responsibility, formerly relegated to gadflies, will be recognized as key corporate governance responsibilities 6. Shareholder communications and proxy voting systems will be revamped by the SEC to make better use of technology, 7. Shareholder resolutions will be overtaken by other forms of constructive engagement, and shareholder activism will become less confrontational 8. The definition of beneficial ownership will become more complicated 9. The spotlight will shift from the governance of companies to the governance of institutional investors 10. Companies will come to recognize that corporate governance is not just a matter of regulatory compliance and accountability but a strategic goal John C. Wilcox, Head of Corporate Governance (TIAA-CREF) Chapter 19 Board Oversight

  31. 10 trends that will shape governance landscape: 2. (3.1) Executive compensation will be brought into line: enhanced SEC disclosure, advisory shareholder votes,, and recognition of internal pay equity. 10. (3.9) Companies will come to recognize that corporate governance is not just a matter of regulatory compliance and accountability but a strategic goal 6. (4.1) Shareholder communications and proxy voting systems will be revamped by the SEC to make better use of technology, 5. (4.3) Sustainability and corporate social responsibility, formerly relegated to gadflies, will be recognized as key corporate governance responsibilities 1. (5.1) Majority voting will become the norm, replacing the plurality vote standard 9. (5.1) The spotlight will shift from the governance of companies to the governance of institutional investors 7. (7.0) Shareholder resolutions will be overtaken by other forms of constructive engagement, and shareholder activism will become less confrontational, 8. (7.2) The definition of beneficial ownership will become more complicated 4. (7.2) The model of the imperial, celebrity CEO will be replaced by the stewardship model 3. (8.0) Separating the roles of chairman and CEO Chapter 19 Board Oversight

  32. Apply Caremark framework… Chapter 19 Board Oversight

  33. Group hypo You are general counsel of Fly Away Airlines, a low-fare airline that’s facing competitive pressures and shareholder demands for more profits The FAA board of directors is considering : PLAN A: The company's employees will work aggressively to comply scrupulously with the law – though this is expensive. PLAN B: The company’s employees will work aggressively to cut costs – of course, compliance with all safety rules may not always be “cost-effective.” Advise the directors on their duties. Chapter 19 Board Oversight

  34. The end Chapter 19 Board Oversight

  35. Role of directors NC Bus Corp Act § 55-8-30 General standards for directors. (a) A director shall discharge his duties as a director ... : (1) In good faith; (2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) In a manner he reasonably believes to be in the best interests of the corporation. Chapter 19 Board Oversight

  36. Chapter 19 Board Oversight

  37. Federal legislative response in 2002 to Enron WorldCom Adelphia Tyco Xerox Global Crossing Chapter 19 Board Oversight

  38. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • Create PCAOB • Audit firms must • register with Board • PCAOB to set new • audit rules • SEC authorized to • go after bad or negligent • conduct Chapter 19 Board Oversight

  39. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • Ban auditors from most • non-audit services • Audit committee must • approve non-audit • services Chapter 19 Board Oversight

  40. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • Rotate audit partner • every 5 years • No “revolving door” for • audit team to company Chapter 19 Board Oversight

  41. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • Stock exchanges must • change listing standards • Audit committee • all independent Ds • Audit committee • “financial expert” • Audit committee • hires/fires auditor Chapter 19 Board Oversight

  42. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • CEO/CFO must certify that • financials “true/complete” • SEC rules on disclosure • of internal controls • Execs certify • Execs can’t improper • influence auditors Chapter 19 Board Oversight

  43. Sarbanes-Oxley Section 404: Management Assessment Of Internal Controls. Requires each annual report of an issuer to contain an "internal control report", which shall: (1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Chapter 19 Board Oversight

  44. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility • Real-time “plain English” • current disclosures • Disclosure of off-balance • sheet arrangements • SEC reviews company • filings every 3 years Chapter 19 Board Oversight

  45. Sarbanes-Oxley • Outside auditors fail to discover or report accounting fraud • Outside auditors’ non-audit services undermine their independence • Outside auditors become too cozy with execs of audit clients • Corporate boards (esp audit committees) fail to watch auditors • Corporate execs oblivious to “truth” of company filings, fail to supervise • Companies fail to report riskiness of true financial position • Corporate cultures encourage irresponsibility, bad practices • Disclosure of code • of ethics • SEC can ban or remove • “unfit” directors/officers • Ban on “Personal loans” • to directors and officers • Exception for • “regular lending” Chapter 19 Board Oversight

  46. Sarbanes-Oxley • Corporate execs sell company stock while aware of fraud, Eees can’t • Outside lawyers “papered” illegal deals and failed to intercede • Securities analysts prepared biased research reports for clients • Courageous “whistle blowers” exposed many frauds • Company officials destroyed documents to cover up • Company officials did not take responsibilities seriously • Execs forfeit pay gains • when company restates • Execs barred from • selling during “blackout” • Insiders must disclose • trades w/in 2 days Chapter 19 Board Oversight

  47. Sarbanes-Oxley • Corporate execs sell company stock while aware of fraud, Eees can’t • Outside lawyers “papered” illegal deals and failed to intercede • Securities analysts prepared biased research reports for clients • Courageous “whistle blowers” exposed many frauds • Company officials destroyed documents to cover up • Company officials did not take responsibilities seriously • SEC requires lawyers • to “report up ladder” • “Securities lawyers” • to CLO or CEO • even to board • not to SEC • SEC enforcement • action for malpractice Chapter 19 Board Oversight

  48. Sarbanes-Oxley • Corporate execs sell company stock while aware of fraud, Eees can’t • Outside lawyers “papered” illegal deals and failed to intercede • Securities analysts prepared biased research reports for clients • Courageous “whistle blowers” exposed many frauds • Company officials destroyed documents to cover up • Company officials did not take responsibilities seriously • SEC rules on analyst • objectivity/ independence • SEC rules protect • analysts from retaliation Chapter 19 Board Oversight

  49. Sarbanes-Oxley • Corporate execs sell company stock while aware of fraud, Eees can’t • Outside lawyers “papered” illegal deals and failed to intercede • Securities analysts prepared biased research reports for clients • Courageous “whistle blowers” exposed many frauds • Company officials destroyed documents to cover up • Company officials did not take responsibilities seriously • Criminal liability for • retaliating • Private action for whistle • blowers, if retaliated • Audit committees set up • (anonymous) procedures • Longer statute of • limitations for fraud Chapter 19 Board Oversight

  50. Sarbanes-Oxley • Corporate execs sell company stock while aware of fraud, Eees can’t • Outside lawyers “papered” illegal deals and failed to intercede • Securities analysts prepared biased research reports for clients • Courageous “whistle blowers” exposed many frauds • Company officials destroyed documents to cover up • Company officials did not take responsibilities seriously • Higher criminal sanctions • for -- • destroy documents • in fed investigation • violate document • retention policies • New crime for obstruction Chapter 19 Board Oversight