Last week’s resignation of Morgan Stanley’s co-President Stephen Crawford—who collected $32 million on his way out the door—highlights the heightened dangers facing corporate directors.

Within hours of Crawford’s resignation, speculation was rampant that Morgan Stanley board members could be facing litigation from investors for allowing such a golden parachute, observes Sarah Wolff, a partner with the law firm Sachnoff & Weaver in Chicago.

Wolff

“Business as usual isn’t business as usual anymore,” notes Wolff, who says that it will be “interesting to see what happens in the Morgan Stanley matter” in light of recent cases from Delaware that have raised the specter of liability for directors who okay favorable executive compensation agreements and otherwise don’t act to protect shareholders.

“Directors today increasingly have to be more attentive to their own preparation in carrying out their own responsibilities,” says Wolff. “They’re more firmly in the sights of regulators and shareholders.”

Michael Gass, a partner in the Boston law firm Palmer & Dodge, tells Compliance Week that—while directors can no longer use ignorance as a defense—they can help protect themselves from liability if they adhere to some basic principles. “Corporate directors who are not part of management cannot know all of the day-to-day occurrences,” Gass notes. “But you can’t be passive. You have to be proactive and aggressive and willing to cross swords with management.”

Wolff notes that, under Delaware law, corporations are allowed to adopt exculpation provisions that insulate directors from personal liability as long as they’re exercising their best business judgment. “If [directors] do their jobs, the courts are going to recognize that exculpation,” she says.

While Wolff notes that it's a “good thing" for directors to take their responsibilities more seriously, he adds that a balance must be struck so that quality individuals are not deterred from serving on boards. “We want to have smart, strong people serving on the boards of directors of public companies,” he says.

Legal Watershed

Under Delaware law, directors have a duty of care that requires them to make informed decisions based on all the material information that is reasonably available to them. They also have a duty of loyalty requiring them to act in a good faith belief that their actions are in the best interest of the corporation and its stockholders—not in their own personal interest.

Gass notes that several recent cases suggest that a breach of the duty of care in approving executive compensation arrangements can itself provide the basis for a breach of the duty of loyalty. This is significant, he says, because of the greater risk of personal liability for directors when they breach the duty of loyalty.

Gass

As a result of what some have labeled a new and expanded duty of "good faith," Gass says directors need to pay particular attention to certain issues, including the heightened obligation to monitor corporate activities to detect and prevent wrongdoing. “Ignorance is no longer an easy defense,” he says. “Instead of sitting back and passively receiving information as provided and packaged by management at monthly or bimonthly board meetings, directors are expected to proactively seek out [necessary] information, to question information that is provided to them, and generally to be proactive in obtaining and processing the information they need.”

A violation of the duty to monitor not only exposes individual directors to liability, but it can also prevent corporations from receiving lighter penalties under the U.S. Sentencing Guidelines if they are convicted of illegal activity, Gass says.

The importance of oversight in the realm of executive compensation has been highlighted in The Walt Disney Co. case, in which the Disney board allegedly spent less than an hour reviewing the hiring of Michael Ovitz, a friend of CEO Michael Eisner, and allowed Eisner to negotiate the terms of Ovitz’s employment and compensation. Ovitz ultimately walked away with a $140 million payout under a termination provision that had apparently never been questioned by the board.

Wolff at Sachnoff & Weaver calls the resulting lawsuit against Disney a “legal watershed”—one in which the shareholders survived a motion to dismiss by alleging that directors “consciously and intentionally disregarded their responsibilities.”

The Disney directors face potential liability, Wolff notes, despite a provision in the Delaware General Corporation Law allowing companies to limit the liability of directories for breaching their fiduciary duty. That protection, contained in Section 102(b)(7), doesn’t cover breaches of the duty of loyalty, actions that were not taken in good faith and other conduct in which a director derives an improper personal benefit.

The Disney court “is upping the ante in failure to monitor cases—it imposed a [standard] for exercise of [the] responsibility [to monitor management] that really hadn’t been placed squarely in the laps of directors before,” she says, noting that the ultimate decision in the case will be “very significant.”

Executive compensation is not an area where a board can defer to the judgment of corporate officers, says Gass, who notes that the Disney case also demonstrates the need for directors to ensure that corporate records truthfully reflect their exercise of control over executive hiring and compensation.

Wolff says that the impact of the Disney case and the availability of Section 102(b)(7) protection are still evolving.

Greater Liability?

She says that another recent case, the shareholder litigation against Emerging Communications, Inc., is particularly notable because the Delaware court held some directors personally liable for damages for voting to approve a going-private transaction at an unfair price. Other directors were held not liable.

The three directors who were held liable—to the tune of more than $77 million—were found to have had “specialized knowledge.” The directors who were cleared of liability did not “cover themselves in glory,” the court said, but they couldn’t be held liable because there was no evidence that they acted with conscious and intentional disregard of their responsibilities or made decisions knowing that they lacked material information.

Directors “who possess expert knowledge may face greater liability exposure for matters within their fields of expertise,” Gass says. “For example, if you have a director who is a certified public accountant with experience in financial reporting matters, and that person is on the audit committee, that person is going to be held to a higher standard with respect to financial reporting matters than someone who does not have that expertise.”

Another case, involving Trace International Holdings, warns directors that they can be held liable for their inaction despite exculpatory clauses, Wolff observes. In the Trace International case, directors were held liable for failing to prevent the controlling shareholder from liquidating the company.

According to Gass, it is a “case-by-case, factually driven inquiry” as to whether a director has done enough under the circumstances. “It will get more clear over time as the caselaw develops and the courts redraw [the] lines. But until the courts redraw the lines, there will be real gray areas. … The better course is always to do more rather than less.”

Transactions with management are an area where directors need to be cautious, he notes. “There are a lot of examples of boards that were not paying attention, acting as a rubber-stamp with respect to dealing with senior management. Sometimes with high-flying companies, where there’s a very prominent CEO who has been very successful, [directors] feel beholden to the CEO, they don’t feel empowered to act as a check on compensation and other issues.”

Directors should also be wary when management reports results that appear to be too good to be true, Gass says.

“Nobody expects directors to have such intimate personal knowledge that they would detect a $100,000 discrepancy in a billion dollar company," he says. "But in some of these scandals the financial reporting has been off by billions of dollars. Where were the directors? What were they looking at? If results just don’t pass the smell test, it’s a fair question. Directors need to be aware of that, and to be careful not to get too giddy [about] the good news that’s beings reported.”

Failure to investigate reports of extraordinary success to confirm that they are real rather than evidence of malfeasance may subject directors to liability for breaching their duty of care, Gass observes.

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