Lucy Marcus, a consultant, Harvard Business Review writer, and corporate director, posted an HP- and Yahoo-inspired cri de coeur Friday at HBR. "How bad does it have to get before we come to terms with the fact that we need to fix the boardroom?" she wrote, in a piece entitled "It Is Time to Fix Our Boardrooms." Marcus's idea is that board should fix themselves. Independent directors have to think hard about who's sitting around the table with them, she said, and "assess whether the board and the individual directors have the skill and the will to rise to the challenge of future-proofing the organizations that they serve."
Marcus doesn't discuss the role shareholders should play in board reform, but the truth is that unless they're Carl Icahn or CalPERS, they have precious little power over corporate directors. (Thanks to the Securities and Exchange Commission's recent decision not to challenge an appellate decision striking down the proxy access rule, shareholders don't even stand much of a chance of ousting directors in favor of their own board candidates.) Ordinary investors should have maximum leverage over corporate boards when they're gathered together in a class action demanding accountability. That vehicle does exist. Derivative suits, in which shareholders stand in the shoes of the corporation to bring class action claims against directors and officers, give investors an opportunity to blame boards for breaching their duties.
Unfortunately, that's about all derivative suits give shareholders, though: an opportunity to air allegations without a lot of hope they'll make a difference. As Tom Hals reported Thursday in an insightful Reuters piece on the dim prospects for derivative suits against Hewlett-Packard, Delaware law makes it incredibly hard for shareholders to win these cases. The Chancery Court's entrenched "business judgment rule," which dates back to 1984, presumes that "in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company." In the 2006 dispute over Disney CEO Michael Ovitz's $100 million golden parachute, the Chancery Court affirmed that under the business judgment rule, "the board's decision will be upheld unless it cannot be attributed to any rational purpose."
Translation: Unless a corporate board behaved with manifest irrationality or demonstrably abandoned its duties, it's insulated from breach of duty claims by shareholders. Gross incompetence is not a viable cause of action. The standard is outright venality. Remember Chancellor Strine's controversial ruling in the Massey case last spring? Strine found that even the coal company's alleged flouting of safety laws and apparent willingness to endanger its employees might not amount to a breach of the board's fiduciary duty for the purposes of a derivative suit.
Boards get yet more protection from the peculiar strictures of derivative litigation. Derivative suits aren't the same as securities class actions, in which shareholders have rights as stock holders. In derivative litigation they're acting on behalf of the corporation, not on their own behalf. (It's a tautology, of course, because they're the nominal owners of the corporation.) So before shareholders can proceed with a derivative claim, they have to either demand that the board take action or show a judge that such a demand would be futile. Either path is difficult. If shareholders serve a demand, boards typically form a special litigation committee of independent directors, and the committee brings in a law firm to advise it. For whatever reason you care to ascribe, it's the very, very rare special litigation committee that ends up recommending the board sue its own members. More often, shareholders will claim demand futility, arguing that directors are too conflicted-usually because of the compensation they receive or their ties to corporate officers-to separate their own interests from those of the corporation. Those are tough claims to prove, especially under Delaware's board-friendly standards.
Occasionally defendants do agree to settle derivative suits (or else they'd be absolutely no reason for shareholders' lawyers to file them). The stock options backdating scandals of the early 2000s, for instance, produced a bunch of derivative deals, including a record-setting $900 million settlement with United Health board members, after the board's special litigation committee actually recommended a suit. Kevin LaCroix at the D&O Diary has a list of the next-biggest derivative settlements: Oracle's board members paid $122 million to resolve insider trading allegations; Broadcom paid $118 million in another backdating case; and AIG directors agreed to two settlements of $115 million and $90 million for claims based on former CEO Maurice Greenberg's alleged self-dealing and AIG's participation in an allegedly sham reinsurance deal.
But as LaCroix and my friend Susan Beck of the Am Law Litigation Daily have written, those derivative settlements are almost always covered by directors and officers insurance policies. Even the cost of defending derivative suits is covered by standard D&O policies. So aside from embarrassment, there's really little consequence for board members from even the rare derivative suit that ends with a sizable payment to shareholders.
No consequence means no accountability for even egregious conduct. It's hard to see how Lucy Marcus's vision of reformed corporate boards can be realized when board members have so little incentive to change.
(Reporting by Alison Frankel)
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