THE FIRST BOOK IN A TWO-PART SERIES OUTLINING THE RISKS

INHERENT IN CORPORATE RESPONSIBILITY, AND PREVENTATIVE

MEASURES DIRECTORS AND OFFICERS CAN PUT INTO PRACTICE

TO MANAGE AND REDUCE THESE RISKS.

DIRECTOR & OFFICER LIABILITYways to get into trouble 01

Director and Officer Liability / Book 012

Congratulations! You have been chosen to serve as a director or officer of a company. This signifies that you have reached a certain prominence in business or in your profession. You may be an entrepreneur who has built your business idea into a viable entity, or an acknowledged expert in your field being sought out to provide counsel and/or management.

Your new responsibilities are much more complex than you may have expected … and becoming more so all the time. Proliferating laws and regulations assign new responsibilities to the company you oversee—and increasingly make you personally liable as a senior official when your company errs. The old Chinese adage (some call it a curse) comes to mind: May you live in interesting times.

You will not be able to rely purely on the business acumen or specialized expertise that earned you your senior position. You must also understand and fulfill a bewildering assortment of other responsibilities. It is no longer always safe to rely on the expertise, experience and ethics of those who will work under your general direction. Instead, more and more laws impose heightened responsibilities to investigate and verify—but rarely provide concrete guidance as to the scope of these additional burdens.

How are you to learn which standards apply and how to meet them? This ebook is the first volume of a two-part publication aimed at answering that very question. This Volume I (Director and Officer Liability I—Ways to Get Into Trouble) outlines the pitfalls associated with directors’ and officers’ corporate responsibilities. Volume II (Director and Officer Liability II—Ways to Keep Out of Trouble) will summarize preventative measures directors and officers can put into practice to reduce the fallout from mis-steps.

introduction

Director and Officer Liability / Book 01 3

contents

Introduction 2

Director and Officer Liability 4Duty to Govern 5Limits of Delegation 6Recordkeeping 7Self-Assessment Checklist 8

Fiduciary Duties 9Duty of Diligence 10Self-Assessment Checklist 12Duty of Loyalty 13Self-Assessment Checklist 15Duty of Obedience 15Self-Assessment Checklist 16

Corporate Lawbreaking 17Violations by the Individual 19Self-Assessment Checklist 21

Responsible Corporate Officer Doctrine 22Self-Assessment Checklist 25

Summary 26

About the Author 27

Director and Officer Liability / Book 014

… ways to get into trouble

If you are a director or an officer you risk personal liability for your efforts, on behalf of your corporation, from many directions and with potentially devastating results. “D&Os” must be aware of this steadily growing risk, as lawmakers and litigators continue to personalize claims against corporations. Since the Millennium, the most dramatic changes in litigation against directors have involved securities law—highlighted by the Sarbanes-Oxley Act of 2002, but also reflected in aggressive actions by regulators and enforcement agencies, shareholders, and others affected by business entities and their management. These actions affect not only publicly traded firms, but many closely held private ones as well.

Recently, however, the major driver of such litigation has shifted to financial and economic issues arising from national and global crises. The massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) imposes additional regulatory requirements and prohibitions to roll back private sector flexibility and fill regulatory gaps that allowed companies to take huge gambles that ended up producing huge losses. The details are beyond this discussion, but examples include formal oversight for many types of credit default swaps and the people who make them, and extension of the federal securities laws to cover additional securities and actors.

These then are litigious times for directors and officers. While Specialty Technical Publishers (STP) publications such as Directors’ and Officers’ Liability and Directors’ Liability in Canada provide comprehensive information, analysis and advice, this short guide is intended to highlight potential pitfalls for individuals who govern corporations (and other forms of organization).

DIRECTOR AND OFFICER LIABILITY

Director and Officer Liability / Book 01 5

Good governance, in simple terms, is legal governance. The board of directors is, collectively, the governing body of the corporation. The board manages and oversees the business and affairs of the corporation, with all the attendant risks and uncertainties, for the benefit of its shareholders. Individual directors constitute the board of directors, and have individual duties to the board, the corporation and the shareholders.

State corporations laws impose on directors a clear duty to govern their corporations, and to discharge their responsibilities in a proper and effective manner. Additional state and federal laws add requirements that directors ensure that their corporations maintain proper records and produce the required reports. These duties create direct liabilities for all corporate directors, and provide us with springboards to case studies and checklists in our discussion here.

Individual Responsibility and Shared Authority on the Board

The precise nature of a directorship is difficult to describe. The term “director” is used but often undefined in applicable laws, except by a circular reference to a person who is a member of a board of directors. Corporation board members are usually described as directors, but they may also be referred to as agents, trustees, or some other similar designation. Regardless of the definition, members of a board of directors are vested collectively with significant powers and responsibilities.

No specific authority is conferred on an individual director by virtue of their position, other than entitlement to sit as a member of the board and to inspect the books and records of the corporation in order to carry out their duties. Directors can only exercise power and authority collectively as members of the board of directors.

An individual director cannot bind the corporation unless the board has specifically granted such authority. Specific authority may be delegated by the board to a committee of directors, or even to an individual director, subject to any general restrictions in the corporate charter and bylaws.

An individual director can wield considerable influence. This may depend on individual qualifications and experience, as they relate to the subject matter being considered. For example, the view of an accountant/director on tax matters, or of an attorney/director on legal matters, may be highly regarded by the chair and the other members of the board.

A directorship is perhaps best described as a supervisory position with the following responsibilities:

administer the assets and business affairs of the corporation in an honest, fair, diligent and ethical manner

act within the bounds of authority conferred

make and enact informed corporate decisions and policies in the best interests of the corporation and its shareholders.

The board also has authority to elect one or more officers, and to assign them to carry out the day-to-day business of the corporation. Officers may or may not also be directors. Corporate officers often include some or all of the following:

chair of the board of directors

vice chair of the board of directors

chief executive officer

president

vice president

secretary and assistant secretary

treasurer and assistant treasurer

any individual designated an officer of the corporation by bylaw or by resolution of the board of directors.

When acting as an officer you have the particular responsibilities and authorities vested in you by the board of directors. You are also subject to general duties similar to some of those borne by directors—including the often less-understood duties of diligence and loyalty. If you are both a director and an officer, then you must be conversant with these duties and be confident in your knowledge of how to meet them.

DUTY TO GOVERN… is, yes, a legal duty

Director and Officer Liability / Book 016

Corporations statutes require boards of directors to justify their titles by directing the corporation’s business and affairs. However, to facilitate effective governance, it is common practice for boards to delegate many of their collective powers to committees focused on particular tasks, such as compensation or audit. Committees operate in the same manner as the board, including being subject to provisions governing meetings and when actions may be taken without a meeting. So far, so good but more complicated considerations are in play.

Boards of directors can also (and typically do) delegate day-to-day management to corporate officers. These delegations are subject to limitations in the corporation’s articles of incorporation, bylaws, or shareholders’ agreement, but generally are quite broad. To make these delegations work, board and committee members are entitled to receive and review records of the corporation and information, opinions, reports, and statements from corporate officers and employees. The board and each director are also entitled to rely in good faith on this information, unless they have reason to doubt the sources.

The danger arises, however, when directors incorrectly assume that such delegation will—or even can—absolve them of potential liability. In fact, in order to curtail possible evasion of legal responsibility, state corporations laws generally prohibit delegation of the most critical decisions, such as:

authorizing or approving distributions, except within limits prescribed by the board

making a proposal to shareholders that requires shareholder approval

filling vacancies on the board, or any board committee

adopting, amending or repealing bylaws.

Delegating these powers to others puts you in breach of state law. Moreover, these invalid delegations cannot transfer liability to committee members.

Your ability to delegate responsibilities assigned by other state and federal laws varies. For a prime

example of a situation in which delegation went wrong consider the following case, decided in 1968 under the securities laws (Escott v. BarChris Construction Corporation):

BarChris Construction Corporation, a builder of bowling alleys, issued debt securities in a public offering. In its registration statement, BarChris overstated its current assets, sales and earnings by substantial amounts. It overstated its backlog of orders by 75 percent, and understated its contingent liabilities and delinquent customer accounts.

BarChris subsequently filed for bankruptcy. Purchasers of BarChris’ convertible debentures brought an action under Section 11 of the Securities Act of 1933, claiming misrepresentation by misstatement and material omission. They easily cleared the first hurdle for a Section 11 action by showing the misrepresentations in the registration statement. But since BarChris was bankrupt, the plaintiffs also sued everyone who had signed the registration statement or participated in the sale of the debentures. Four officers and directors all asserted they had met their duties of due diligence.

The court examined the respective roles the individual officers and directors had played, and considered “expertised” (i.e., based on a qualified professional’s expert judgment) and “non-expertised” parts of the registration statement, in order to assign liability. The court held that the only “expertised”, certified part of the registration was the auditor’s financial statements. The court rejected all four officers’ due diligence defenses, based on the following analysis.

Kircher, treasurer and CFO, had personally worked on the registration statement, and so was in a position to know the facts belied by the misrepresentations. The court found that he knew the truth and lied to the accountants about it. His claim that he was never specifically asked for certain information, that would have made the registration statements true or complete, fell far short of satisfying the due diligence defense.

Birnbaum, secretary, director and house counsel, was found liable for misstatements in the non-expertised part. Although apparently unaware of the misrepresentations, Birnbaum relied on corporate officers’ (mis)representations. The court noted that he

LIMITS OF DELEGATION…you can’t really pass the buck

Director and Officer Liability / Book 01 7

could readily have conducted his own inquiry using his access to corporate documents such as minutes of meetings and contracts.

Grant, director and outside counsel, had actually drafted the registration statement and so was held to the high standard of care owed by an insider. Although he was entitled to rely on the accounting firm for the expertised part, he failed due diligence with respect to the non-expertised part. He should have examined corporate agreements and minutes of meetings, and investigated actual or potential conflicts of interest among officers, directors and managers. He failed to check some financial items, such as the overstated backlog, that he could readily have verified. Although ignorant that the statements he

drafted were false, his failure to scrutinize any of these areas sank his due diligence defense.

Auslander, an outside director, did not personally investigate the facts behind the registration statement. Although he had been appointed to the board just a month before the offering, the court held that he could not rely on the knowledge and representations of other officers and directors for the non-expert part.

The different bases for the BarChris defendants’ liability offer every sort of director a cautionary tale in due diligence. To avoid liability, each potential defendant needs to substantiate facts and representations (in this case in the corporation’s registration

statement) by an independent inquiry that includes review of corporate records and documents. Furthermore, corporate players should be nosy, even when they are “new on the block”—as the hapless Auslander discovered. Remember that you will bear the burden of showing that your investigation was reasonable.

Directors’ duty to manage the affairs of their corporation includes responsibility to ensure that the corporation keeps proper records and makes reports required under federal and state laws. Specific reporting requirements vary according to the type and nature of the business, but they consistently include the following:

federal, state and local tax returns

compliance reports to federal, state and local agencies.

It is important that directors recognize and exercise their right to examine the stock ledger

of the corporation, its list of stockholders, and all other books and records that reasonably relate to their duties as directors. Because directors’ purview covers ensuring that proper recordkeeping procedures are being followed, maintaining access to (and being knowledgeable about) those records is essential in avoiding potential liability. Ignorance of the information contained in records does not absolve directors of their legal liability, so directors must take a conscientious and assertive approach to familiarity with all corporate recordkeeping. If you, as a director, are refused access

to corporate records, state laws generally permit you to obtain a court order to enforce inspection.

Directors who rely on summaries, reports and corporate records in the performance of their duties are protected by statutes in all states, but proving knowledge of such records is essential. Always keep in mind that if you are a director it is you, not the accountant, who is ultimately accountable. The BarChris case, summarized above, should remind you of that. How can directors avoid a situation such as the one cited above? Let’s move on to our first checklist.

RECORDKEEPING…hitting the books

Director and Officer Liability / Book 018

for Delegation of Duty and Recordkeeping

1. Verify that you understand the board’s ultimate responsibility to govern the corporation.

Has the board of directors delegated management of the corporation to any other individual or entity?

2. Verify that you understand the restrictions on the authority of board committees.

Do you know the limits of each board committee’s authority over:

• distribution of shares?

• actions that require shareholder approval?

• filling vacancies on the board or the committee?

• adopting or amending bylaws?

• fixing directors’ compensation?

• other actions governed or restricted by the state of incorporation?

• other actions governed or restricted by the corporation’s articles of incorporation or bylaws?

3. Verify that you understand the corporation’s recordkeeping requirements.

As a member of the board, have you verified the corporation meets recordmaking, recordkeeping and reporting responsibilities?

4. Verify that the corporation files necessary reports.

As a member of the board, have you checked that the corporation files the following:

• required tax reports and returns?

• reports to applicable federal and state regulators?

• if a public corporation, filings with:

– Securities and Exchange Commission (SEC)?

– stock exchanges where the corporation is listed?

5. Verify that persons who provide information, reports, or statements on which you rely are qualified to do so.

Have you verified the qualifications of individuals and organizations that provide information, reports or statements to the board, and/or to you?

6. Verify that you oversee the business and affairs of your corporation.

Do you continue to exercise your individual judgment in management of the corporation?

Yes No

Yes No

Yes No

Yes No

Yes No

Yes No

SELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 01 9

… my corporation, my shareholders

Directors and officers owe formal duties to their corporations and shareholders, commonly called “fiduciary duties” from the Latin root words for “trust.” These duties developed over centuries of common law, and now appear in state corporations codes. Shareholders can sue a director or officer claiming he or she has breached one of these duties. These cases can be complicated because common law concepts tend to be defined by catch-phrases summarizing vague ideas, which only accrue meaning through years and years of court decisions. Because of these vagaries, the duties often overlap so one inappropriate action may breach more than one fiduciary duty. Also, keep in mind that the jury’s perception of a director’s inaction can be just as powerful a factor in legal decisions as the perception of active wrongdoing.

Directors and officers are generally liable for a breach of any of these fiduciary duties if the plaintiff — usually an aggrieved shareholder — also demonstrates that the breach caused a loss, or that a loss would not have occurred but for failure to fulfill the duty. It can be difficult to show that the breach actually caused the loss. Losses often result from external factors—for example, increased competition in the marketplace unforeseeable by even the ablest directors. The loss, therefore, may not point directly to the directors’ and officers’ failure to meet the required standard of care. But even successful defenses can be expensive and time-consuming.

Although state liability provisions are not entirely consistent, most include the following sorts of liability:

money damages for harm suffered by the corporation, or its shareholders, as a result of the directors’ action or inaction

other compensatory payments, such as repayment for unauthorized use of corporate assets

payments under equitable theories, such as disgorgement of profits.

Generally, fiduciary duties are distilled into three categories of obligations: the duty of diligence, the duty of loyalty and the duty of obedience.

FIDUCIARY DUTIES

Director and Officer Liability / Book 0110

Directors and officers must conduct themselves (including governance of the corporation and oversight of its employees and activities) “with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” You will notice that the language of this standard, reflecting its common law roots, is not crystal clear. Shareholders, who may suffer substantial losses, want to hold directors to a high standard, however vague this common law definition of “duty of diligence.” You, as a director, must be aware of these expectations.

Also vague is the standard defense offered by directors and officers, known as the business judgment rule. To invoke it, courts apply a presumption that properly functioning boards of directors are best equipped to manage the corporation’s affairs, so board decisions should not usually be second-guessed by courts (or the plaintiffs). To qualify for its protections, however, a decision or action must have been made:

by disinterested directors (i.e., absent, self-dealing or conflicts of interest)

with a reasonable belief that it was in the best interests of the corporation

in good faith

on an informed basis

for a valid business purpose.

Shareholders challenging a board decision must rebut this presumption by bringing forward facts that tend to negate one or more of these qualifying elements. If they can do so, then they typically must show that the officers and directors committed not just “negligence” but “gross negligence.” A highly publicized case arose from the Disney Company’s brief and expensive relationship with Michael Ovitz (In re Walt Disney Co. Derivative Litigation – 2006):

In April 1994 the death of Disney Company President Frank Wells, in a helicopter crash, set off succession issues which became urgent three months later when Disney’s Chairman/CEO and interim president, Michael Eisner, underwent quadruple bypass heart surgery. Over the next year, Eisner, and other Disney board members, discussed possible successors. Eisner took personal charge of the search, and ultimately settled on his

longtime friend Michael Ovitz. Ovitz was the founding partner of a highly successful talent agency, Creative Artists Agency (CAA). Although CAA’s business was quite different from Disney’s, Eisner believed that Ovitz’s skills and personal and professional connections made him a worthy candidate.

Ovitz was also an expensive and demanding candidate. To induce Ovitz to leave his lucrative position ($20–25 million per year, based on his 55 percent ownership of CAA), Eisner and the chair of Disney’s compensation committee (Irwin Russell) agreed on a base salary of $1 million annually plus performance incentives, and 3 million shares in stock options over 5 years (projected to be worth at least $50 million by the end of the initial 5 year contract term), plus 2 million more shares upon signing the first renewal. This package was estimated to be worth $23.6 million per year over 5 years, comparable to Ovitz’s income from CAA but very high for his new position as chief operating officer of a public company such as Disney. They also negotiated a lavish severance package should Ovitz be terminated not-for-cause: $7.5 million for each year left in the original 5 years, immediate vesting of the 3 million shares, plus $10 million to compensate for loss of the second 2 million shares.

After Eisner and his small team negotiated these terms, they were transmitted to Disney’s board for approval. After minimal review by Disney’s compensation committee and full board, the board approved Ovitz’s hiring.

Despite the optimism surrounding Ovitz’s courtship and hiring, his tenure was short, stormy and unsuccessful. He proved unable to acculturate to Disney’s operations and high-level staff, and clashed frequently with Eisner over personal styles and strategic visions for the company. Ultimately, Ovitz was fired after 14 months on the job. The board accepted advice that the termination was not-for-cause and honored the termination agreement, at a cost of some $90 million.

Shareholders filed a derivative action, charging that Eisner and Disney’s other directors had breached their fiduciary duties in connection with both Ovitz’s hiring and subsequent firing.

After a very extensive decision recounting the history of the incident, and excoriating Eisner and some other directors, Delaware’s Court of Chancery nevertheless

DUTY OF DILIGENCE…keeping your eye on the ball

Director and Officer Liability / Book 01 11

ruled for the defendant directors. The Chancellor found support for the reasonableness of the compensation levels (and hence no “waste” of company assets). Furthermore he held that the directors’ actions were insulated by the business judgment rule. Noting the potential gap between the aspirations of good corporate governance, and levels of governance so bad that a director should be personally liable for his or her failings, the Court stated:

Unlike ideals of corporate governance, a fiduciary’s duties do not change over time. How we understand those duties may evolve and become refined, but the duties themselves have not changed, except to the extent that fulfilling a fiduciary duty requires obedience to other positive law. This Court strongly encourages directors and officers to

employ best practices, as those practices are understood at the time the corporate decision is taken. But Delaware law does not—indeed, the common law cannot—hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices, any more than a common law court deciding a medical malpractice dispute can impose a standard of liability based on ideal—rather than competent or standard—medical treatment practices, lest the average medical practitioner be found inevitably derelict. [Emphasis added.]

The duty of diligence and the business judgment rule appear in a variety of situations you may encounter as a director or officer. When read together, they serve to require that boards do the following:

oversee the affairs and business of their corporation

act with prudence when making business decisions

make decisions in good faith, based on legitimate reasons

act independently and free from outside considerations or influence

make decisions on an informed basis (which may require “reasonable inquiry”), recognizing that it is generally reasonable to rely on the competence and integrity of other directors and officers, and on hired experts.

Turn the page to test whether you are exercising due diligence.

Director and Officer Liability / Book 0112

1. Verify that you meet standards of care when performing your duties as a director or officer.

Do you apply at least the care and skill of an ordinary prudent person to all actions you take as a director or officer?

Do you devote the necessary time and effort?

Do you stay aware of new developments in the affairs of the corporation?

2. Verify that you make informed decisions.

Do you attempt to uncover all relevant facts before you make a decision?

Do you solicit advice and information from experts, management and other directors?

Do you conduct your own investigations?

Do you weigh all the pros and cons before you act (or refrain from acting)?

Do you exercise your judgment independently of management and other directors?

3. Verify that your actions meet the conditions of the business judgment rule.

Do your actions have valid business or corporate purposes?

Are your actions based on the belief that they are in the best interests of the corporation?

Are your actions taken on an informed basis?

Are your actions taken without any self-interest or conflict of interest?

Are your actions based on good faith decisions?

Yes No

Yes No

Yes No

for Duty of DiligenceSELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 01 13

This duty requires you, as a director or officer, to deal fairly with your corporation. Typical state law codification of this duty provides “Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes is in the best interests of the corporation.”

Your duty of loyalty applies in a variety of situations where conflicts of interest may arise between the individual and the corporation. In all these situations you, as the individual director or officer, must be sure to act in ways that are fair to the corporation. The most common situations involve the following:

transactions between a director or officer and the corporation

transactions between corporations with interlocking directorships

exploitation of corporate opportunities

competition with the corporation

situations with a potential for change of corporate control.

If a director’s transaction violates this duty, a court can void the transaction—as happened when, in February 2004, the Delaware Court of Chancery found that Conrad Black had committed self-dealing in securing $70 million in “noncompetition” payments via secret negotiations with a team seeking to buy one or more companies under his control (Hollinger International, Inc. v. Black, 844 A.2d 1022 (Del. Ch.2004); affirmed 872 A.2d 559 (Del. 2005)). The court found the following:

Conrad Black is an international player in a variety of publishing enterprises. Through a hierarchy of companies, Black was the ultimate controlling owner of Hollinger International (a NYSE-listed company that was the primary operating company for Black’s newspaper assets), and the dominant shareholder of Ravelston Corporation Limited (a privately held company), which in turn owned 78 percent of Hollinger, Inc. (a company listed on the Toronto Stock Exchange), which in turn had 72.8 percent voting power in International (through a combination of holdings of Class A shares), and Class B shares (each of which had 10:1 voting preference over

DUTY OF LOYALTY…hands above the table

Published by Specialty Technical Publishers, these guides identify the duties and responsibility of directors and officers, and provide detailed information on how they can avoid liability and minimize personal risk.

Written in plain language

Provides a comprehensive, authoritative analysis of pertinent federal and leading-state/provincial laws and precedents

Highlights emerging issues

Assists directors in avoiding criminal and civil sanctions in areas such as environmental law, worker safety, and civil rights facilitated by use of the Do’s and Don’ts checklists.

Directors’ and Officers’ Liability (US) and Directors’ Liability in Canada

It covers niches in subject areas that you don’t find elsewhere.”** Customer research study conducted by Hebert Research in December, 2011.

Director and Officer Liability / Book 0114

Class A shares). At the beginning of the events addressed in this case, Black was chairman of the board and CEO of all three companies and, according to the decision in this case, held himself out to the world as controlling all three.

In May 2003, one of International’s other major shareholders wrote to International’s board of directors demanding investigation of over $70 million in “non-competition” payments to Black, two other directors of International whom Black had nominated (and in other capacities, employed), and another International executive. Because the dispute involved several board members, and raised questions about the effectiveness of other directors’ oversight, the board added three new outside directors and appointed them to a Special Committee to investigate the complaint. The Special Committee decided the payments were inappropriate and unauthorized, and called for urgent action. In response, Black resigned as CEO but continued to chair the board while the other targeted directors resigned their positions with International, and the disputed payments were to be repaid. International’s board also agreed to undertake a “Strategic Process” on behalf of International, which might include a sale of some assets and/or ownership interests, with Black committing formally to “devote his principal time and energy to pursuing the Strategic Process with the advice and consent of the Executive Committee and overall control of the Board.” The Special Committee continued to pursue matters.

At about this time, in violation of this written agreement and despite his fiduciary responsibilities to International, Black was in private negotiations with the Barclay brothers, who are also media magnates. The remainder of the International board had some indication of Black’s failure to pursue the Strategic Process, and even of his dealings with the Barclays. During the same period, the Securities and Exchange Commission (SEC) was also investigating International.

Matters finally came to a head in January 2004. On January 16, International and SEC filed a consent order committing International to allow the Special Committee investigation of self-dealing to continue unhindered, and defining conditions under which effective control of International might be handed over to the Special Committee. On the same day, the Special

Committee sued Black and several others for self-dealing.

On January 17, International’s board voted to remove Black as chairman, although he remained on the board. Later that day, Black provided the board with formal written notice that he had reached a deal with the Barclays to sell them his interests in Hollinger, effectively transferring to them control of Hollinger without triggering various “poison pill” provisions designed to protect minority shareholders, and short-circuiting the Strategic Process. This transaction would have awarded Black a significant “control premium” in the price he was to receive.

When the International board began meetings to look for ways to thwart the sale, Black caused Hollinger to table amendments to International’s bylaws repudiating the board’s structural changes and substituting a requirement for unanimous consent by directors to a range of further changes. In response, the independent directors voted to reject these amendments as violations of Black’s duty to International, adopted further poison pill measures through a new Rights Plan, and sued Black and his various other companies to void their changes. This also voided Black’s deal with the Barclays as tainted by self-dealing in violation of Black’s duties to International.

In its decision in International’s suit against Black, the Court recognized that no specific state statute or terms within International’s bylaws prohibited Black’s dealings. However, the Court applied equitable considerations to an exhaustive recitation of the history and outcome of Black’s dealings, and issued an order enjoining Black’s bylaw amendments and the Black-Barclays deal, and validating the Rights Plan adopted by the independent directors.

This decision reflects a strong reaffirmation of directors’ traditional duties to their companies.

On the following page you will find a checklist to help assess how well you are fulfilling the duty of loyalty.

for Duty of LoyaltySELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 01 15

1. Avoid conflicts of interest with your corporation.

If there is any likelihood of an actual or perceived conflict of interest, have you disclosed it in a written notice to the board of directors?

Have you avoided discussing with outsiders the matter giving rise to any apparent conflict?

After disclosing the conflict to the board, have you absented yourself from any meeting that considered the matter, and refrained from voting on any resolution pertaining to the matter?

Have you followed the specific requirements pertaining to material contracts or transactions, as set out in applicable state corporations law?

Yes No

The duty of obedience requires you, as a director or officer, to comply with (“obey”) the applicable state corporations statute and other applicable laws, and with the charter, articles, and bylaws of your corporation. Board members can be held personally liable to the corporation for damages that result from failure to do so.

One important application of the duty of obedience is to financial matters. For example, most states allow corporations to write provisions eliminating or limiting directors’ liability for most actions into corporate articles of incorporation, but bar such protections from covering a “financial benefit received by a director to which the director is not entitled.” Examples of financial dealings where this issue arises include the following:

executive compensation, including salary and benefits, stock options, and severance packages (including “golden parachutes”)

loans and other forms of financial assistance to directors, officers or shareholders

redemption of shares

distribution of assets

declaration and payment of dividends.

Liability for breaches of this duty varies with the situation. Individuals can be liable to the corporation to repay excessive compensation, or transactions may be cancelled (as happened to Conrad Black in the case discussed above). State corporations laws commonly provide that directors who authorize or consent to a loan to a fellow director or an officer, or to unlawful dividends, are jointly and severally liable for the amount of the loan.

The handy checklist that follows will help you gauge your efforts to adhere to the duty of obedience.

DUTY OF OBEDIENCE…no one is above the law

for Duty of ObedienceSELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 0116

Yes No1. Verify that executive compensation is not excessive and accords with

industry standards.

Have directors’ fees been determined by a compensation committee of the board comprised of outside directors?

If the company is a public corporation, have you obtained a report from the chief financial officer (CFO) that:

• limits on tax deductibility are recognized and met?

• proper disclosures are made to the SEC?

Have you ensured that any “golden parachute” compensation packages have been duly considered and recommended by the board’s compensation committee, after advice from the corporation’s accounting and legal counsel?

Have you verified that stock options are not excessive in relation to the services to be received, and that the corporation has a reasonable expectation of receiving the services for which such options are granted?

2. Verify that loans and other financial assistance comply with applicable requirements.

Have you obtained a report from the corporation’s accountant(s) or CFO to ensure that the corporation meets the applicable solvency test?

If your corporation’s securities are traded on a national securities exchange, have you confirmed that any loans made to directors or officers comply with restrictions in federal securities laws?

3. Verify that redemptions or purchases of shares are made out of retained earnings or surpluses.

If your corporation has a share redemption plan, have you verified that it meets applicable corporations law provisions and any restrictions in its certificate of incorporation?

4. Verify that dividends are made out of surplus or profits.

Have you obtained a report from the accountant(s) or CFO verifying that the corporation will remain solvent if the company pays dividends?

Have you obtained a report from the CFO to ensure that the payment of dividends complies with the applicable corporations law provisions?

Has any preferred stock rights dividend or special dividend been considered and recommended by a board committee based on outside expert advice?

Has the CFO certified that the surplus and solvency tests have been met?

Yes No

Yes No

Yes No

Director and Officer Liability / Book 01 17

… as below, so above

Individual leaders can be liable for lawbreaking that occurs in their organizations. These general concepts apply in corporate settings, where the corporation and any number of its directors, officers and employees might be guilty of a crime. This obviously includes situations whether (or not) the individual actually takes part in the violation. Culpability can also be shared based on the so-called “alter ego doctrine,” under which prosecutors and civil plaintiffs can “pierce the corporate veil” to reach miscreant directors and/or officers.

Individual Misuse of the Corporate Form … Dr. Jekyll and Company Hyde

Corporations and other business forms are designed to separate owners from liability for actions taken by the businesses in which they invest. However, owners who abuse this separation can be reached. One phrasing is the “alter ego doctrine,” under which individuals cannot escape responsibility for actions and debts by carrying on business as a corporation unless the corporation is

CORPORATE LAWBREAKING

Director and Officer Liability / Book 0118

indeed a separate and distinct legal entity, and acts like one. In cases that raise this doctrine courts look to see whether the corporation has a separate identity and pursues its own interests, or is simply an alter ego through which the owner(s) or controller(s) pursue their personal interests. Another formulation of the same approach involves “piercing the corporate veil” to impose personal liability upon an individual, such as the chief executive officer, a director or the controlling shareholder.

A number of circumstances can lead a court to pierce the corporate veil under the alter ego doctrine.

The director or other individual, such as a dominant shareholder(s), is using the corporate entity to do the following:

– perpetuate a fraud

– avoid the effect of a statute

– evade an existing obligation

– protect crimes

– achieve or perpetuate a monopoly

– justify a wrong.

The controlling person manages the corporation’s business affairs in a manner such that individual or corporate creditors may be deprived of their legal rights and remedies.

Corporate formalities are not being adhered to.

The corporation is inadequately capitalized.

Consider the following lawsuit under the federal Superfund law (Carter-Jones Lumber Company v. Dixie Distributing Company and Harry Denune (1999)):

Harry Denune was the president, chief executive officer and only shareholder of Dixie Distributing Company (Dixie). Dixie sold transformers containing polychlorinated biphenyls (PCBs) as scrap to a salvage liquidation business located on property owned by the Carter-Jones Lumber Company (Carter-Jones). During an inspection of the site, the Ohio Environmental Protection Agency (Ohio EPA) discovered that the transformers were damaged and leaking PCB-containing oil onto the ground. Carter-Jones subsequently signed a consent decree with Ohio EPA, spent $3 million on cleanup and then sued Denune and Dixie seeking contribution. The District Court found liability for both defendants.

On appeal, the Court of Appeals examined Denune’s personal liability under the Superfund law as an “arranger-for” the disposal of hazardous waste. The Court upheld the District Court’s ruling, determining that Denune was liable as an arranger-for disposal due both to his status as Dixie’s sole shareholder, and because of his “intimate participation” in arranging for the transformers’ disposal. The Court, in piercing the corporate veil, stated that Denune “may not hide behind his officer or employee status in Dixie to claim that because he took all actions on behalf of the company he cannot be personally liable.”

Securities Law: A Guide to the 1933 and 1934 Acts and their Amendments, including Sarbanes-Oxley and Dodd-Frank

Published by Specialty Technical Publishers, this detailed guide provides a thorough explanation and analysis of the two central federal statutes, the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act). The 1933 Act controls the registration of securities with SEC and national stock markets, and the 1934 Act controls trading of those securities. These laws require public companies and certain persons to publicly disclose facts that would be material to an investor’s decision to buy or sell securities, and impose civil and criminal liabilities on those who fail to comply.

It gives me info so that we can be compliant.”**Customer research study conducted by Hebert Research in December, 2011.

Director and Officer Liability / Book 01 19

Anyone can be held civilly, or even criminally, liable for violations that he or she plans or in which he or she is an active participant. This can be true even if the individual doesn’t personally commit the crime. People can act together as equals, or a leader can delegate illegal acts to a subordinate. Individual directors and officers can be held individually liable for their corporation’s violations of a wide variety of federal, state, and even local requirements, a partial list of which follows.

Employment law, e.g.:

1. Wages and benefits—including federal Fair Labor Standards Act (FLSA)

2. Worker safety—including federal Occupational Safety and Health Act

3. Antidiscrimination requirements—including federal Title VIII, Americans with Disabilities Act, Family and Medical Leave Act, Age Discrimination in Employment Act

4. Immigration laws—including federal Immigration Reform and Control Act

5. Pension and benefit plans—including federal Employment Retirement Income Security Act (ERISA)

Taxation regulations—income, sales, employment, etc.

Environmental protection, e.g.:

1. Air quality—including federal Clean Air Act

2. Water quality—including federal Clean Water Act and Safe Drinking Water Act

3. Hazardous waste management—including federal Resource Conservation and Recovery Act

4. Solid waste management—including federal Solid Waste Disposal Act

5. Species and ecosystem protection—including federal Endangered Species Act, Migratory Bird Treaties

6. Cleanup and corrective action laws—including federal Superfund Act, and corrective action and cleanup provisions under a variety of laws

Product safety, labeling and consumer protection laws, including Federal Trade Commission Act, Consumer Product Safety Act, Poison Prevention Packaging Act, Toxic Substances Control Act.

Antitrust, fair competition, and antimanipulation laws.

VIOLATIONS BY THE INDIVIDUAL …cutting corners can cost

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Securities laws, for publicly traded companies and privately held companies that have issued securities under conditional exemptions from federal and state securities laws.

These laws generally assess civil fines for violations. A corporation that fails to pay wages or taxes as required, or that releases unpermitted pollutants, is subject to these fines. Some of these laws also provide personal liability for directors, officers and/or managers. Personal liability can arise in several ways:

An individual can make a required certification and fail to ensure performance of the activity being certified. For example, since adoption of Sarbanes-Oxley in 2002, chief executive officers and chief financial officers of public companies must certify that company financial statements are accurate and comply with applicable requirements. The CEO and CFO are personally liable for failure to certify, and for inaccurate or false certifications.

The corporation can fail to comply with an employment law provision that treats individual directors and/or officers as an “employer” who is individually subject to requirement. For example, a director can be personally liable under the FLSA for wages the corporation fails to pay—as a deliberate violation (such as nonpayment of overtime rates) or even because the company declares bankruptcy with wage payments due.

The individual can breach a fiduciary duty to establish or monitor the corporation’s employee or retiree benefits plan, and become liable under ERISA for resulting losses to the plan or beneficiaries.

Individuals may even be liable for criminal violations by the corporation. Criminal liability traditionally requires “mens rea” —Latin for “guilty mind” —which means knowledge of the action/inaction and knowledge that it breaks the law. However, some contemporary prohibitions reinterpret this standard of knowledge to mean “willfulness,” which requires knowledge of the action or inaction, but does not require the prosecutor

to prove knowledge of lawbreaking. Consider the following case, which involved criminal prosecution for what may have been an inadvertent violation of national hazardous waste management requirements (United States v. Hoflin):

Douglas Hoflin was director of the Public Works Department of Ocean Shores, Washington. He was responsible for road maintenance and also for operation of the municipal sewage treatment plant. From 1975 to 1982, Hoflin and his successor bought 3,500 gallons of paint for road maintenance activities. When Hoflin became director for the second time in 1983, he told Fred Carey, director of the sewage treatment plant, that he planned to bury 14 leftover 55-gallon drums of paint at the sewage treatment plant. Carey suggested that burying the drums at the plant might jeopardize the plant’s Clean Water Act permit, but Hoflin said he would bury them there anyway. Sometime in August 1983, following Hoflin’s direction, an employee took the paint drums to the plant site and buried them. In doing so, the employee crushed the drums with a front-end loader to make them fit, then covered the refuse with sand.

In March 1985, almost two years later, Carey reported the incident to state authorities, who in turn notified the Environmental Protection Agency (EPA). EPA exhumed and tested the drums and found that 10 of the 14 contained hazardous waste. The Resource Conservation and Recovery Act (RCRA) allows hazardous waste disposal only at a properly permitted facility and the sewage treatment plant had no such permit. EPA prosecuted and the jury convicted Hoflin for disposal of the paint in violation of RCRA

On appeal, Hoflin contended he had not known that Ocean Shores had no permit to dispose of the paint, and so therefore could not have “knowingly” violated RCRA by having the drums buried. The Court of Appeals for the Ninth Circuit rejected Hoflin’s claim and held that “knowledge of the absence of a permit is not an element of the offense” for which Hoflin was convicted.

To obtain an idea of whether you are steering clear of corporate and personal lawbreaking, turn to the checklist on the next page.

Director and Officer Liability / Book 01 21

1. Verify that your company operates as a distinct entity, and that its distinct interests are protected.

Has your corporation been organized in compliance with all applicable state statutes?

Does the corporation operate as an entity distinct from its owner(s) and controller(s), in pursuit of the interests for which it was organized?

2. Verify that your own actions comply with applicable laws and regulations.

Have you identified laws and regulations applicable to the corporation?

• Have you identified which of these requirements apply to your own corporate responsibilities and activities?

Have you determined the activities necessary to comply with these requirements?

• Have you determined whether the corporation complies with these requirements?

• Do you provide personal oversight to ensure compliance?

• Do you receive reports from personnel responsible for ensuring compliance, sufficient for you to ensure compliance?

3. Verify that actions under your responsibility comply with applicable laws and regulations.

Have you identified laws and regulations applicable to the corporation?

• Have you determined whether you may be personally liable for the corporation’s failure to comply with any of these requirements?

Have you determined the activities necessary to comply with these requirements?

• Have you determined whether the corporation complies with these requirements?

• Do you provide personal oversight to ensure compliance?

• Do you receive reports from personnel responsible for ensuring compliance?

Yes No

Yes No

Yes No

for Corporate and Personal LawbreakingSELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 0122

… it’s not what you know, it’s who you are

What if a corporate director or officer lacks direct knowledge of employees’ illegal actions? If, in this capacity, you have met the duty of diligence, you have breached no fiduciary responsibility. And, if your diligent review didn’t uncover the wrongdoing, then you would not meet the traditional standards for culpability under the legal frameworks described in the previous section. But be warned: nontraditional standards may also apply!

The responsible corporate officer (RCO) doctrine defines situations where corporate officers are liable for employees’ activities, even without direct proof that they knew of the employees’ illegal activities, let alone that those activities were illegal. However, contrary to some reports, this doctrine does not impose strict liability based solely on corporate position. Instead, cases have found liability where all three of the following apply:

Position: The individual is in a position of responsibility, allowing him or her to influence corporate policies or activities.

Nexus: There must be a close enough link (“nexus”) between the individual’s position and the violation, showing that he or she could have influenced the actions that resulted in the violation.

Action or inaction: The individual’s action or inaction must have facilitated the violation.

This standard is closer to prosecution for “willful ignorance” of knowledge a responsible corporate officer should have about the activities under his or her control, especially in situations where those activities are potentially hazardous.

RESPONSIBLE CORPORATE OFFICER DOCTRINE

Director and Officer Liability / Book 01 23

The RCO doctrine dates back to a 1943 decision by the U.S. Supreme Court (United States v. Dotterweich):

Joseph H. Dotterweich was the president and general manager of the Buffalo Pharmacal Company. The company, a “jobber” in pharmaceuticals, purchased drugs from the original manufacturers, repackaged them under the Buffalo Pharmacal label and shipped them to retailers. Some of the drugs placed in interstate commerce by Buffalo Pharmacal were found to be “misbranded” and “adulterated,” in violation of the Food, Drug and Cosmetics Act (FDCA). Although Dotterweich claimed ignorance, the trial court found him guilty. On appeal, the Second Circuit Court of Appeals reversed. On further appeal to the Supreme Court, however, Justice Frankfurter ruled that the FDCA is one of a:

... now familiar type of legislation whereby penalties serve as an effective means of regulation. Such legislation dispenses with the conventional requirement for criminal conduct—awareness of some wrongdoing. In the interest of the larger good it puts the burden of acting at hazard upon a person otherwise innocent but standing in responsible relation to a public danger. Balancing relative hardships, Congress has preferred to place it upon those who have at least the opportunity of informing themselves of the existence of conditions imposed for the protection of consumers

before sharing in illicit commerce rather than to throw the hazard on the innocent public who are wholly helpless. [Emphasis added.]

Here the person with the “burden,” the individual with “at least the opportunity” of taking action, was Dotterweich. The Supreme Court reversed the Court of Appeals’ decision, agreeing with the district court that Dotterweich was guilty of a misdemeanor. Dotterweich was assessed a $500 penalty plus 60 days probation.

In 1975, the Supreme Court revisited and reaffirmed the RCO doctrine in United States v. Park:

John R. Park was the chief executive officer of Acme Markets, a national retail food chain. Investigation by the federal Food and Drug Administration (FDA) revealed that food held for sale in a company warehouse in Baltimore was “adulterated” (contaminated by rodents) in violation of the FDCA.

The government prosecuted Acme and Park. At trial, the FDA offered testimony that it informed Park by letter of the conditions at the warehouse. Park testified that although he received the FDA letter, it was his practice to delegate “normal operating duties” such as sanitation to “dependable subordinates,” reserving for himself only those things relating to “the big, broad, principles of the operation of the company.” Park also testified that he relied on advice from Acme’s vice president for legal

Director and Officer Liability / Book 0124

affairs, who informed him that the Baltimore division vice president “was investigating the situation immediately and would be taking corrective action ....” Park asserted that he did not believe he could have taken any further action that would have been constructive. The trial court convicted Park, a decision reversed by the Court of Appeals for the Fourth Circuit.

The Supreme Court, relying on its opinion in Dotterweich, reversed the Fourth Circuit. The Court noted that:

... in providing sanctions which reach and touch the individuals who execute the corporate mission ... [FDCA] imposes not only a positive duty to seek out and remedy violations when they occur but also, and primarily, a duty to implement measures that will insure that violations will not occur. The requirements of foresight and vigilance imposed on responsible corporate agents are beyond question demanding, and perhaps onerous, but they are not more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and well-being of the public that supports them. [Emphasis added.]

The Supreme Court reversed the Court of Appeals’ decision, agreeing with the district court that Park was guilty of five counts of violating FDCA.

The FDA has applied this approach in the subsequent decades. Most recently, in January 2011, FDA promulgated an explicit policy for prosecuting misdemeanors under what it calls the “Park Doctrine.” This policy provides the following directive:

When considering whether to recommend a misdemeanor prosecution against a corporate official, consider the individual’s position in the company and relationship to the violation, and whether the official had the authority to correct or prevent the violation. Knowledge of and actual participation in the violation are not a prerequisite to a misdemeanor prosecution but are factors that may be relevant when deciding whether to recommend charging a misdemeanor violation. [Emphasis added]

Other factors to consider include but are not limited to:

whether the violation involves actual or potential harm to the public

whether the violation is obvious

whether the violation reflects a pattern of illegal behavior and/or failure to heed prior warnings

whether the violation is widespread

whether the violation is serious

the quality of the legal and factual support for the proposed prosecution

whether the proposed prosecution is a prudent use of agency resources.

Since Dotterweich and Park were decided, the RCO doctrine has been extended to a handful of additional public health, public welfare and/or environmental contexts. These include the following:

federal Clean Water Act (statutory provision)

federal Clean Air Act (statutory provision)

federal Radiation Control for Health and Safety Act (since renamed Electronic Product Radiation Control Act and merged into the FDCA)

federal Health Insurance Portability and Accountability Act (HIPAA)

California’s underground storage tank law.

In contrast, the U.S. Supreme Court refused to apply Dotterweich and Park to hold the president of a real estate brokerage personally responsible, under the federal Fair Housing Act, for racial discrimination by one of his salesmen (Meyer v. Holley (2003).

Flip the page for a checklist that will indicate whether you have been acting as a responsible corporate officer.

Director and Officer Liability / Book 01 25

1. Inform yourself about activities at your facility, especially those that may affect public welfare.

• Haveyoureviewedalloperationsunderyourauthorityorcontrolthatmayaffectpublichealthandsafety?

• Haveyoureviewedwhethertheactivitiesunderyourauthorityorcontrolcomplywithpublicwelfarestatutes(e.g.,environmentalhealthandsafetylaws)?

• Doyoureceiveregularreportsonactivitiesunderyourauthorityorcontrol?

• Haveyouestablishedanongoingsystemformonitoringtheseactivities?

• Doyouensurethatactivitiesunderyourauthorityandcontrolcomplywithapplicablerequirements?

Yes No

for Responsible Corporate OfficerSELF-ASSESSMENT CHECKLIST

Director and Officer Liability / Book 0126

… play to win, but follow the rules

Jon Elliott’s next ebook, Director and Officer Liability II — Ways To Keep Out of Trouble will provide additional guidance, focusing on steps to avoid liability in the areas of corporate compliance, ethics, and risk management programs, as well as directors’ and officers’ indemnification and insurance.

Let’s face it, there are lots of ways things can go badly for corporate directors and officers. Your job is to evaluate the corporation’s activities and opportunities, and to participate with your fellow directors and officers in setting, and then following its course. It’s not humanly possible to get every decision right, and even some correct decisions fail to turn out as well as you hope.

Fortunately, corporations codes and other applicable laws and regulations recognize human fallibility. Read together, they offer substantial causes for concern, but also ways to operate successfully:

Traditional common law duties all start with the individual D&O’s intentions—if you are diligent, loyal, and obedient, your decisions should be insulated against lawsuits based in the common law.

Most modern laws and regulations articulate relatively clear mandates and prohibitions, providing space for you and your corporation to prosper. But you have to make use of your staff and outside professionals to identify milestones and landmines along the way.

summary

Director and Officer Liability / Book 01 27

ABOUT THE AUTHOR

Jon F. Elliott BSE, MPP, JD

Jon Elliott has made a major contribution to the Specialty Technical Publishers (STP) product range for over 25 years.

His impressive list of publications includes:

Securities Law: A Guide to the 1933 and 1934 Acts

Directors’ and Officers’ Liability

Workplace Violence Prevention: A Practical Guide

As well, he has produced the following publications relating to environmental and occupational health and safety:

CAL/OSHA: Compliance and Auditing

ChemCheck Handbook

Complete Guide to Environmental Law

Complete Guide to Hazardous Materials Enforcement and Liability: California

Environmental Compliance: A Simplified National Guide

Environmental Compliance in California: The Simplified Guide

Federal Toxics Program Commentary (including Matrix Wall Chart)

Hazardous Materials Program Commentary: California (including Matrix Wall Chart)

OSHA Compliance: A Simplified National Guide

U.S. Federal Mandatory Greenhouse Gas Emissions Reporting Audit Protocol

He continues to write quarterly updates for these, and many other, important publications.

Mr. Elliott has a diverse educational background. In addition to his Juris Doctor (University of California, Berkeley Boalt Hall School of Law–1981), he holds a Master of Public Policy (Goldman School of Public Policy, UC Berkeley–1980) and a Bachelor of Science in Mechanical Engineering (Princeton University–1977).

Mr. Elliott’s professional experience includes:

Practicing attorney in California.

Compliance consultant and legal advisor (since 1985), specializing in projects that address multiple legal frameworks simultaneously.

Instructor in University of California Extension professional certificate programs.

Director and Officer Liability / Book 0128

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