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What Enron/WorldCom Really Means for Directors

News that outside directors agreed to pay a combined $33 million in out-of-pocket legal settlements for their roles in the collapses of Enron and WorldCom has set off a buzz of concern in director circles, and with good reason. That presumably smart people with good legal advice decided they were better off paying than fighting shatters what was once an article of faith: that, while they can and will get sued, directors would never have to open their own wallets for lapses that occur on their watches.

Do directorsu00e2u20ac”particularly bank directorsu00e2u20ac”have anything to fret about?

The legal experts are quick to note that Enron and WorldCom were exceptions, and they’re probably right. In both cases, independent investigations found directors were asleep at the switch while management led their companies to demise. The settlements, they add, were just thatu00e2u20ac”settlements, not court rulings, and in wildly egregious cases, no lessu00e2u20ac”and there’s no reason to believe that such stalwart director defenses as the business judgment rule and good faith have suddenly vanished.

“I’m confident these are aberrational cases,” says H. Rodgin Cohen, a partner at Sullivan & Cromwell in New York. “If they aren’t, then why would anyone sit on a board? The risk-reward ratio [for directors] would be so totally out-of-whack that it would severely damage our corporate governance system.”

That’s no doubt true. Even so, directors are undeniably worried that a precedent has been set and that they, too, could be forced into paying out personally. Evan Rosenberg, a senior vice president with Warren, New Jersey-based D&O insurer Chubb Corp., says he’s seen a big jump in requests by individual directors for personal coverage, and for so-called “Side-A” coverage, bought by companies to protect individuals. That’s despite the fact that, with plaintiffs intent on extracting financial penalties from board members themselves, no insurance product would have helped the WorldCom or Enron directors.

“I get directors asking questions about [the settlements] all the time,” says Robert Clarke, a partner at Bracewell & Patterson in Houston and a former comptroller of the currency. “There’s a sense that it’s riskier to be a director.”
Norman Veasey, former chief justice of the Delaware Supreme Court, seconds the notion. While he told a recent gathering of auditors that the settlements’ ramifications have been overblown in the press, he also warned that they amount to “blood in the water” for the plaintiffs’ bar and give institutional investors like those behind the suits a “tactical advantage and momentum” to press for further damages.

The investors themselves offer little reassurance. Alan Hevesi, New York’s state comptroller and lead plaintiff in the WorldCom case, boasted his settlement “sends a strong message” to other directors “that we will hold them personally liable” for fraudulent activities at their companies. Asked if she would advocate going after the personal assets of other directors in some cases, Christy Wood, senior investment officer for global equity at pension giant CalPERS, replies: “If not that, then what? What’s our ultimate recourse? … I’m disturbed about going down a path where we say to directors, ‘You have no liability.’ Where would that leave shareholders?”

This is scary stuff for directors of all sorts. For those who serve on bank boards, the risks are theoretically higher. Banks are guardians of people’s money, as well as a load of personal informationu00e2u20ac”both touchy areas, prone to litigation. The financial nature of the business means they also tend to issue more bonds and other securities than the average company. (Poor due diligence of registration statements was at the root of the WorldCom directors’ woes.)

What makes banking truly different from most other industries, however, may be the level of regulation. Clarke, who ran the OCC between 1985 and 1992, notes that the thrift crisis of that era spawned tighter oversight and requirements for strong internal audits, risk management, and policies and procedures. “When you have these types of things in place, it’s a lot harder for things to fall through the cracks,” he says.

Having examiners looking over the shoulders of boards and managements on a regular basis, meanwhile, is a double-edged sword. On one hand, those second opinions can be a reassuring safety switch for boards. “A good regulator will alert boards to problems, usually before they become big ones,” Cohen says. “The offset,” he adds, “is they’re more likely to find violations, because there are so many regulations to run afoul of.”

What should smart bank directors do? For one, keep personal business separate from the bank’s. Personal liability is more likely to emerge from breaching the duty of loyalty, Cohen says. He offers the example of a director who doesn’t disclose that he has a substantial equity stake in a potential borrower. “A bank can indemnify [directors] for failure to exercise due care, or even for failure to act in the best interests of shareholders, but not for a breach of loyalty,” he explains.

Directors would also do well to listen closely to their gutsu00e2u20ac”and regulatorsu00e2u20ac”when it comes to management, and to leave if they’re uncomfortable with what they’re hearing. “You shouldn’t be on a board if you don’t have confidence in the CEO,” says Martin Lipton, a partner at Wachtell, Lipton, Rosen & Katz in New York.

Beyond that, boards should focus on processes and procedures. Directors of banks that actively securitize and sell different types of loans, for example, can’t be expected to examine the details of every offering. But Clarke says they should make sure periodic filings, like 10Ks and 10Qs are accurate, and that they have a sound, documented process that delegates responsibility and ensures proper due diligence for episodic filings.

The best way to avoid trouble: Make sure your bank stays financially healthy and follows the rules. “You should only wind up with a risk of personal liability if you have a total insolvency, like WorldCom,” Cohen says. Directors who keep their eyes and ears open and use the help that’s available should face little risk of personal payments at all.
u00e2u20ac”John R. Engen

CFOs Help to Shape Strategy

Chief financial officers are facing new challenges and higher expectations than ever before, according to a recent survey of 1,600 senior financial executives by global consulting firm Booz Allen Hamilton and CFO Research Services. A new breed of CFO is responding by taking on an expanded and increasingly active role. These “activist” CFOs are intimately involved with boards of directors, helping to shape corporate strategy and serving as trusted advisersu00e2u20ac”and sometimes successorsu00e2u20ac”to CEOs.

Overall, the study found CFOs are working much more closely with corporate boards than in the past. In fact, 44% of respondents said their CFO interacts with the board of directors more significantly than two years ago. This is particularly true of “activist” CFOsu00e2u20ac”60% of respondents from activist companies said their CFOs have increased their interaction with the board over the past two years.

Closer board relations are also tied to times of operating distress. Of respondents indicating increased board interaction, 38% also acknowledged a need to overhaul their company’s operating model; 30% revealed external pressure from analysts for change; and 27% reported significant executive turnover. The respondents with no change in board relations indicated significantly less company distress.

The survey results show growth, rather than cost control, is the most common agenda for today’s finance executives. In fact, three-quarters of all respondents believe a focus on top-line growth will be a greater contributor to earnings over the next three years than cost containment. The majority of this group (54%) sees more value in generating new products and services than in focusing on executing the basics, compared to 28% of respondents from companies with below-average profitability that are in need of cost control and dramatic change.

“Activist CFOs are reinventing the corporate finance organization and forming much stronger relationships with boards of directors,” said Vinay Couto, vice president at Booz Allen. “In some cases, such as PG&E and Cendant, boards take the next step and fill high-profile CEO or president vacancies with the CFO they know and trust.”

Audit Committee Chairs Have Positive Outlook

Grant Thornton LLP recently conducted a survey of public bank audit committee chairmen. The Survey of Public Bank Audit Committee Chairmen was initiated to determine the experiences of public bank audit committee chairmen since the passage of the Sarbanes-Oxley Act while also ascertaining their general attitudes and opinions on the business of community banking.

What the survey found is that like the bank executives surveyed in a similar research project, audit committee chairmen have an optimistic outlook for 2005, with 75% reporting an optimistic (7%) or somewhat optimistic (68%) view of the national economy. Furthermore, 77% have an optimistic (17%) or somewhat optimistic (60%) outlook for community banking.

“It’s good to see that so many bankers and chairmen have such a positive outlook for 2005,” says John Ziegelbauer, managing partner of Grant Thornton’s U.S. financial institutions industry practice. “With this optimism, it’s not surprising that more than three in five bankers and chairmen also think the country is moving in the right direction.”
What are the issues audit committee chairmen view as important for community banks’ future success? Almost all audit committee chairmen and executives of community banks (more than nine in 10) say attracting new business customers is important to their banks’ continuing success; at the same time, two-thirds of audit committee chairmen express confidence in their bank’s performance, while only 53% of executives do. Similar to their banking counterparts, 94% of audit committee chairmen also believe retaining deposits is important to the success of their banks, and approximately three-quarters of them are confident in how their bank is addressing this challenge.