These days the business pages are crammed with news of companies that have gotten into trouble. Whether it's allegations of Foreign Corrupt Practices Act violations or involvement in insider trading, there's no shortage in claims of corporate malfeasance—substantiated or not. Directors, especially those who serve public companies, recognize their resulting exposure to reputational damage and financial loss. While concerned, most take comfort in their ability to carry out the required duties of loyalty and care. They act in good faith and rely on the well-established business judgment rule.

The Delaware Chancery court also offers reasonable comfort.  Chancellor William Chandler and his vice chancellors do a great job ensuring appropriate protection of board members working to carry out their challenging responsibilities, while supporting shareholders' legitimate rights. And the Delaware Supreme Court operates on the same wavelength.

That being said, directors of some companies have paid a dear price for alleged misconduct, with their names sullied and their personal assets levied. Yes, indemnification provisions along with appropriate directors and officers insurance (including such provisions as Side A coverage) usually prevent personal exposure. But concern justifiably persists, and expanding federal government regulations and several recent cases don't serve to help directors sleep comfortably at night.

Beazer Homes

We know there are many shareholder lawsuits, especially when corporate performance fails to meet expectations. The case of Beazer Homes, however, has an interesting twist. Plaintiffs argue that the company's executive compensation plan rewarded managers for poor performance, thereby shortchanging shareholders. Two Teamster pension funds reportedly accuse the company's directors of not acting in shareholders' best interests in authorizing increases in CEO and other executive pay while the company was losing money. The funds' lawyers added that the pay raises “violated the company's pay-for-performance policy and favored Beazer's CEO and top executives at the expense of the corporation.”

Have these directors heard the saying, “What happens in Vegas, stays in Vegas?” Do they recognize that the same holds true for what happens in the boardroom?

The shareholders filed the lawsuit shortly after the homebuilder was forced to restate earnings. The SEC had accused it of falsifying reports to increase income, and, according to media reports, the chief accounting officer was indicted on charges of securities fraud and obstruction of justice. In the current shareholder suit, the pension funds' lawyers reportedly pointed to the board's approval of pay raises—7.2 percent for the CEO and 37 to 150 percent for other executives— even though the stock price fell over 17 percent in value. The raises were “windfalls for the Beazer executives responsible for the company's 2010” losses, the lawyers said.

While this case centers on fraud allegations and earnings restatements, one can wonder whether board members of other companies might face similar legal action where executives received higher pay as performance sagged.

The SEC in Action

The Securities and Exchange Commission has also brought some recent cases that have involved directors. True, the SEC is somewhat hamstrung with budgetary issues, challenging its ability to move forward with developing regulations and programs for implementing Dodd-Frank Act provisions, but that hasn't stopped the agency from initiating actions against corporate directors when it deems appropriate.

Take the case of DHB Industries, now called Point Blank Solutions, which makes body armor for the military. The company's chief executive and chief operating officers reportedly were accused of “manipulating financial records to boost earnings and profit margins, and thus inflate DHB's stock price,” and convicted of fraud in a New York federal court last September. Now, the SEC is pursuing three outside directors who served on the company's audit committee. The SEC says they were “willfully blind to numerous red flags” of fraud, thereby enabling management to take millions of dollars to pay for luxury cars, vacations, and prostitutes. The SEC's regional director added: “This massive accounting fraud permeated throughout an entire company… As the fraud swirled around them, [the directors] ignored the obvious.” The SEC is seeking injunctive relief, disgorgement of ill-gotten gains, monetary penalties, and a bar on the directors from service as officers or directors in the future.

Then there's the well-publicized case of Rajat Gupta, who operated at the highest echelons of multinational business. The SEC charged Gupta in March with illegally passing inside information to Raj Rajaratnam, the Galleon Group founder on trial for charges of insider trading. Gupta, a Harvard Business School graduate and former head of McKinsey & Co., has been a board member of blue chippers Goldman Sachs, Proctor & Gamble, and AMR, parent of American Airlines.

The SEC alleges that Gupta gave Rajaratnam advance information about earnings at both Goldman and P&G. On top of that, the SEC maintains that Gupta called the Galleon head with the inside scoop of the Goldman Board's approval of Warren Buffett's $5 billion investment in the firm. The allegations speak to multiple phone calls between the two men, enabling Galleon to reap millions in profits. What must be particularly troubling for both is that the SEC has recordings of telephone conversations and has been playing them for the jury.

Of course Gupta is innocent until proven guilty, but let's presume for a moment that the allegations are factual. Is this a black eye for the companies where Gupta sat on the board, or for other directors on those boards? (By the way, Gupta reportedly did not stand for reelection to the Goldman board and has since resigned from P&G and AMR). My answer, based on the information available, is “no.” Certainly, if the allegations are true, a statement by SEC Director of Enforcement Robert Khuzami is on point: “Mr. Gupta was honored with the highest trust of leading public companies, and he betrayed that trust by disclosing their most sensitive and valuable secrets.” But what could or should have been done to prevent wrongdoing at the board level?

We know well how important it is for a company's board to keep a close eye on what the CEO and senior management team are doing and on the company's system of internal control. We recognize the importance of compliance officers, risk officers, and internal audit functions. But who keeps an eye on the actions of individual directors, especially when their actions are outside the inner workings of the company itself? We can look to what happened years ago at Hewlett Packard, when a board member leaked information to the media, which resulted in the well-known pretexting fiasco. Have these directors heard the saying, “What happens in Vegas, stays in Vegas?” Do they recognize that the same holds true for what happens in the boardroom?

There are no immediate answers, other than to continue to ensure full vetting of director candidates and to maintain effective board and internal audit processes to best identify and manage potential misbehavior. But it is worth more thought going forward. 

Need for Concern?

Board members might take comfort in statements by Khuzami, who has indicated that he and his staff will go after outliers, not those directors working diligently to carry out their difficult responsibilities. In connection with the DHB action he said: “We will not second-guess the good-faith efforts of directors. But in stark contrast, [these] were directors and audit committee members who repeatedly turned a blind eye to warning signs of fraud and other misconduct by company officers.” And in connection with the action against Rajat Gupta, he said: “Directors who violate the sanctity of boardroom confidences for private gain will be held to account for their illegal actions.”

Do directors need to worry? My view is that they do, but no more so than in the past. By acting with integrity and diligence and in the best interests of their companies and shareholders—certainly the norm for the vast majority of directors—sleeping well at night shouldn't be a problem.