Directors beware

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Investors are looking for scalps and insurers have warned that companies worldwide – not just in the US, where shareholder actions are more common – face potentially ruinous litigation claims for losses caused either as a direct result of their own actions and failure to manage risks effectively, or through their exposure to those companies that followed high-risk strategies. Insurance market Lloyd’s of London has warned that businesses could be facing a future liability crisis if they do not face up to growing litigation issues. In its report called “Directors in the Dock – is business facing a liability crisis?” published in May, Lloyd’s urges businesses to anticipate and prepare for future liability risks potentially arising from the credit crunch.

Lloyd’s research has shown that boards everywhere are feeling increasingly challenged by litigation and are spending more time and money addressing these issues. Key findings include the fact that two-thirds of European business leaders expect to spend more time on litigation-related issues over the next three years, and that two in three business leaders believe that the scale of liability claims arising from the credit crunch will exceed those arising from the dotcom crash.

By the end of 2007, the credit crunch had sparked a 58 percent rise in the number of class-action lawsuits filed by US shareholders against companies and their directors. Research has found that lawyers filed 207 class-action cases last year, up from 131 in 2006. The average settlement also soared to $32.2m, up nearly 50 percent on 2006. The median pay-out also hit a high of $10m, according to NERA Economic Consulting, an international firm of economists. So-called mega-settlements, worth $100m or more, accounted for nearly one in 12 of all settlements. Before 2000 they accounted for, at most, two percent of payouts.

The first of the sub-prime related securities class action lawsuits were filed in February 2007, just as the problems in the sub-prime marketplace began to surface. Since then, as the sub-prime-related problems developed into a more generalised credit crisis, the associated litigation has also grown. As of October 1, 2008, there have been 120 sub-prime and credit crisis-related securities class action lawsuits filed, in addition to 23 derivative lawsuits and 15 ERISA lawsuits.

Breaching fiduciary
As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the events of Black September 2008. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint in New York state court against the company, as nominal defendant, and a certain number of directors and officers. The complaint alleges that the company’s planned merger with Bank of America is the result of a “flawed process and unconscionable agreement” and that the defendants had breached their fiduciary duty.

Similarly, on September 18, 2008, AIG shareholders filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s “exposure to and grossly imprudent risk taking in the sub-prime lending market and derivative instruments.” The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

In addition, on September 24, 2008 plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against certain directors and officers of Lehman Brothers, on behalf of persons who purchased shares in the company’s February 5, 2008 offering of preferred securities. The complaint also names the offering underwriters as defendants. The complaint alleges, among other things, that the offering documents did not accurately reflect the company’s true financial condition, because the defendants had failed to appropriately write-down both the company’s sub-prime mortgage portfolio and its portfolio of commercial and residential real estate assets.

So far, directors in the UK have managed to avoid litigation for their part in the downfall of their firms. In October nationalised lender Northern Rock said it would not take legal action for negligence against the executives in charge of the bank before its collapse. Management said a review by lawyers and accountants into the management led by Chief Executive Adam Applegarth found “insufficient grounds” to proceed. The probe also concluded that the firm’s auditors should also avoid any action.

But UK lawyers do not discount the possibility that directors of other organisations severely impacted by the credit crisis will not be treated so favourably. “There’s only so long before someone in the UK realises that the courts are the only real recourse he has to get justice for his pension fund being depleted and the shares in the bank he invested in being worthless. Once that happens, directors will need to be very aware of the consequences of their actions and the risks their organisations are taking,” says one UK corporate lawyer.

Pressure cooker
Experts also agree that as companies are under increased pressure to show shareholders that they can still perform well in a depressed economic climate, it is increasingly likely that company directors will need to make sure that risks facing the business are properly assessed, mitigated and controlled and that corners are not cut simply to reduce costs.

The UK’s Companies Act (2006), which came into effect in 2007, states that the duty of directors is to act in a way which they consider most likely to promote the success of the company for the benefit of its shareholders as a whole and that, in doing so, they will need to have regard “where appropriate” to long term factors, the interests of other stakeholders and the community, and the company’s reputation. As a result, risks need to be identified and managed properly. And in an economic downturn, there are arguably more risks to consider.

One of these key risks is whether the directors are keeping a tight rein on the organisation’s operations and ensuring that while the business may be taking an “aggressive” strategy to stay competitive in the current climate of economic turmoil, it is not acting illegally or outside the bounds of corporate governance best practice. If it is, then the directors could well be in the firing line for regulatory action and/or investor lawsuits. 

And it is not just full-time executive directors that can be targeted. Some recent scandals have shown that non-executive directors can be at the centre of colossal fraud trials and damages claims. Recent examples include Lord Wakeham, formerly a non-executive director at disgraced US energy company Enron, who suddenly found himself being summoned to the US to provide testimony in the world’s most notorious corporate fraud trial.

Under UK law, all directors have a legal duty to display not only a reasonable level of skill, care and diligence in the discharge of their functions, but also to bring to bear such knowledge, skill and experience as they have. Furthermore, UK company law does not distinguish between executive and non-executive directors and thus both sets of directors share the same duties and responsibilities to shareholders, regulators and other stakeholders. The dismissive remark once given by executive ITV Chairman Michael Grade about likening non-executives to bidets (“you’re not sure what they’re for, but they add a touch of class”) – which perhaps once captured the passive nature of the role – no longer holds true. Non-executives are equally as culpable as executives.

Risk management
In the case of UK life insurance firm Equitable Life which came close to collapsing in 2000, the troubled insurer’s non-executives were forced – following a regime change at the company’s board – to enter the witness box in the context of a £2bn claim against them to defend their actions. One of the main planks of their defence was to the effect that the risks surrounding guaranteed annuity rates were a highly technical matter on which they had to rely on the good judgement of the actuaries, the other professionals and the executive, and therefore they should not be held equally culpable.

But the UK’s financial services regulator has made it clear that such an attitude is no longer tenable. Shelia Nicoll, director of the FSA retail firms division, has warned that the regulator now plans to interview “more of those applying to hold significant influence functions at the largest firms”. 

In a speech on September 17, Ms Nicholl said: “We certainly expect that those we interview will go on to be approved – those invited to interview as part of our scrutiny process should not feel that they have been singled out for attention. We have run pilots and we expect and hope that those we interview will take up their new roles more conscious of their regulatory responsibilities. You should, however, be clear that FSA approval of significant influence functions is not a ‘tick box’ exercise.”

Ms Nicholl said that while the FSA appreciates that it cannot expect non-executive directors to have the same grasp of detail as executives who work full time for a group, she added that “we expect them to ask the challenging questions, to understand the business models and sources of profit in the firm, along with the risks which those entail. So, if you agree to be a non-executive director of a regulated firm or a group containing regulated firms, you must expect us to assess your competence and to hold you to account if you have not conducted yourself in a way which falls below the standards we reasonably expect of non-executive directors.”

“Boards which are mere paper tigers can be worse than useless because they give false reassurance of high standards – of checks and balances – where none exist,” said Ms Nicholl. “We aren’t ignorant of the difficulties which medium-sized firms have in getting hold of good directors, but my personal view is that a firm is better served by having a smaller number of hard working, well paid non-executive directors than a larger number of token ones.”

Lawyers also believe that the current financial climate may compel directors to take greater credit risks. Danny Davis, partner in the insolvency practice at law firm Mishcon de Reya, points out that while the UK is heading for recession, there is going to be increased pressure on companies to push back payment deadlines with suppliers while trying to get customers to pay more rapidly. As a consequence, he says, there are going to be more instances of companies trading while heading for insolvency.

“The credit crunch is going to make some directors take bigger risks with regards to how they try to manage their cashflow,” says Mr Davis. “It is increasingly likely that more companies will be heading for insolvency in the coming months, and directors need to make sure that their companies do not trade while insolvent – or are about to go insolvent – in an attempt to keep the business running.”

Mr Davis adds that directors should also not make the mistake of thinking that the company’s tax payments are not as important as payments to suppliers. “Time and again we see court cases where companies are filing for insolvency and they haven’t paid the taxman because they mistakenly thought HM Revenue and Customs was the least important creditor. Companies in difficulty often believe that their tax payment can simply be made at a later date – often without telling HMRC why – so that funds can be used ‘constructively’ to pay staff, suppliers, stockholders, utilities, lease holders and so on first. This is nonsense and is not favourably looked upon by the courts.”

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