The Board’s Role in Bringing Legal Trouble to an End

When civil litigants agree to settle their disputes, they expect judicial approval, if not praise. The rubric of our judicial system is that litigation should be discouraged, and settlements of filed lawsuits should be encouraged.

This expectation is even more pronounced if the government is one of the parties. Courts understandably show great deference to the government and rarely reject its proposed settlements; government agencies lack the resources to litigate large numbers of cases and use settlements to educate others on the proper reach of the law. Indeed, the Securities and Exchange Commission depends upon settling a high percentage of the cases it brings.

But this fall, Judge Jed Rakoff rejected the SEC’s proposed settlement with Bank of America (BofA). His reasoning was cogent: The SEC claimed BofA defrauded its own investors, and both parties proposed to settle the action by—among other things—charging BofA’s innocent and victimized shareholders $33 million for the privilege! Lest those with short memories chalk this up as a judicial quirk, the same judge approved the SEC’s proposed settlement with WorldCom years ago, which sought (and obtained) a $750 million penalty in a case alleging serious accounting fraud that damaged hundreds of thousands of investors.

Judge Rakoff’s BofA decision spotlights the obligations of corporate directors asked to approve a proposed settlement that includes a corporate penalty or fine. Because this isn’t a rare occurrence—especially given the SEC’s ramped-up enforcement efforts—directors should consider how they would respond to proposed settlements that may involve the imposition of a penalty. The essential point is not that boards should now reject settlement proposals that include penalties and fines, but rather, that boards should not assume that, merely because the government and management have agreed upon a proposed resolution of the government’s concerns, the proposed resolution necessarily is in the best interests of their company and its shareholders.

The Problems With the BofA Settlement

Notwithstanding the advantage of hindsight, this observer does not believe criticism of the parties in the BofA case is appropriate. After all, it cannot be said that there are no appropriate circumstances under which companies should pay a fine or penalty for their allegedly illegal acts—if that were the case, Congress presumably wouldn’t have authorized the SEC to seek, or vested courts with the power to grant, such remedies (albeit in appropriate cases). Nor is it true that merely because the burden of a corporate fine or penalty will be felt most heavily by those innocent shareholders still with the company that any imposition of a corporate fine or penalty is per se unfair. It has long been the case that corporate misconduct can lead to one class of innocent shareholders bearing the brunt of the burdens of corporate misconduct for the benefit of another class of innocent shareholders.

Class actions often seek recompense for injured former shareholders at the expense of current shareholders, even though the current shareholders had no more knowledge of the improper corporate behavior than the former shareholders. Similarly, criminal actions targeting public companies often impose fines upon corporations that perpetrated the criminal behavior, even though the penalties and fines will be borne by innocent shareholders. And, corporations are often sued for misconduct or tortious acts of their employees, and are forced to pay significant monetary damages, even though the misconduct wasn’t committed by the shareholders of the company that will now have to bear the burden of the damages award.

One reason for these phenomena is that owning a corporation carries responsibility for improper acts perpetrated by the company. The law repeatedly resolves competing concerns among innocent parties by assigning liability to those believed most appropriately should bear responsibility for someone else’s improper conduct. Thus, for example, in a hypothetical situation where a trucking company driver violates company policy and drinks during a driving assignment, the innocent victims of an accident caused by the driver’s inebriation often can recover from the innocent public shareholder-owners of the trucking company, even if the company had appropriate policies in place, and the driver was not inebriated when he left the company’s garage.

The problem with the BofA settlement is that neither party was able to articulate a cogent reason that the settlement was in the interest of the company and its shareholders.

One reason liability, on occasion, is borne by innocent shareholders is that part of the risk one assumes in owning a company is the possibility that the company and its managers may engage in wrongdoing, and that wrongdoing can reduce or eradicate the value of a shareholder’s investment. It is also the reason that corporations enjoy limited liability—if innocent investors are to be assessed for conduct about which they didn’t know, their liability exposure is limited to the value of the corporation and does not usually include their personal assets.

The problem with the BofA settlement wasn’t that it sought to impose a fine on the company; rather, the problem with the BofA settlement is that neither party was able to articulate a cogent reason that the settlement was in the interest of the company and its shareholders. Had the penalty been a more manageable number, Judge Rakoff’s decision suggests he might have accepted the rationale that the expense and burden of litigation outweighed the payment of a civil fine. Unfortunately, the BofA fine—$33 million—was more than even the high-priced lawyers representing BofA could likely run up. Alternatively, had there been a meaningful rationale for the penalty selected, the outcome might have been different. But, it appears neither party satisfied the Judge’s request for a rationale linking that particular remedy to any legitimate outcome for BofA’s shareholders.

New Rules

If settlements by public companies remain appropriate—even though they contest the legitimacy of the Government’s charges—a new methodology must be used to avoid the result that a case the government was willing to settle and a company was willing to accept, nonetheless must be tried. One powerful reason for avoiding litigation is that the only certainty in a lawsuit is the outcome’s uncertainty. Here are some suggested approaches for corporations to consider:

Adopt an advance response methodology. Preparing before subpoenas start flying, class-action litigation commences, or government comes calling is always better than the alternative. Any methodology created in advance still must be tailored to particular circumstances, but will permit immediate responses and strategy development.

Don’t overload audit committees. There’s a tendency to overwork audit committees. While audit committees have a role to play, especially if litigation relates to financial reporting improprieties, the audit committee itself may have relevant information and data that should be assessed from a fresh perspective, rather than merely assuming the audit committee got it right when the issue arose. Companies should consider establishing separate quality legal compliance committees to handle these and related matters.

The board should make its own independent assessment of the merits of any claims. While blindly supporting attacked executives may feel good, boards’ responsibilities require understanding of what occurred, whether it’s improper, who’s responsible, who was injured, and what consequences will befall the company if it chooses to fight or switch.

The board should understand the charges to be alleged against the company, and the collateral consequences of settling, especially vis-à-vis the government. While there are many justifications for settling litigation, government settlements are neither cheap nor without strings. Settling any litigation has collateral consequences; boards must know what they are.

A board committee should oversee company responses to government litigation and shareholder class actions. Corporations are legal fictions and cannot commit illegal or improper acts by themselves. Only individuals can violate the law. A board committee needs to oversee positions taken in response to government contentions or shareholder litigation claims.

Factors boards should consider in settling government actions. In the BofA case, the judge was concerned that Ken Lewis, BofA’s CEO, might have had responsibility for the alleged fraudulent proxy disclosures. But, BofA’s Board never independently reviewed whether he was culpable and, even if so, there was a shareholder interest in retaining him nonetheless. Boards should consider issues like the following:

Will the proposed settlement make it easier/harder to focus on its future operations?

What impact will settling have on employee morale?

Will a proposed settlement make it easier/harder to attract qualified corporate executives?

If a fine or penalty is involved, how was the amount derived? Has it been reviewed by an independent economist?

Are there other remedies—apart from, or instead of, a penalty or fine—that might better serve shareholder interests?

Has the board received independent advice regarding the appropriateness of the proposed settlement?

Can the board articulate reasons the proposed settlement is in shareholders’ interests?

If a fine or penalty is involved, has the board also considered whether it should seek to recover some or all of it from those responsible for the alleged misconduct?

7. Has the board memorialized its deliberations? Whether or not the board settles an action, it’s useful to prepare either a brief report, or a resolution, describing factors considered, conclusions reached, and a rationale for the action. The only way a board can satisfy itself, its shareholders and, ultimately, a federal judge, is by creating a record that shows the board’s thoughtfulness, care and business judgment.

Conclusion

Many corporate executives and boards understandably view a government investigation or a shareholder class action as if it were a bad case of “ring around the collar.” The company has to confront hordes of attorneys, accountants, and government officials, and will divert an incredible amount of manpower, not to mention incurring large costs, as long as the investigation or class action lingers on. But, while putting such diversions behind a company is often very positive, in light of the BofA decision, boards should ensure that their actions also reflect good corporate governance.