When former WorldCom and former Enron directors in January separately agreed to dip into their own pockets to partially settle shareholder lawsuits, some pundits proclaimed a new era of director vulnerability to future litigation.
But, several weeks later, the WorldCom deal apparently collapsed when a judge in the case struck down another key provision of the agreement.
As you recall, 10 former outside directors of WorldCom—now known as MCI—agreed to pay $54 million, including $18 million from their own pockets, to settle part of a class-action lawsuit brought by investors burned by the telecom giant's accounting scandal.
As the deal was structured, it would have increased the exposure of 16 investment banks that are also defendants in the case. These banks, of course, opposed the deal.
Earlier this month, U.S. District Judge Denise Cote sided with the banks—including JP Morgan Chase—when she ruled that any jury award could not take into account the limited finances of the directors who settled. According to experts, the banks had been arguing that the director settlement might have limited their ability reduce damages if, for example, the jury attached some blame to the directors.
As a result of the ruling, the plaintiffs withdrew from the deal. "The so-called 'ability-to-pay' provision at issue was a necessary part of the settlement," said New York State Comptroller Alan Hevesi, in a statement. The upshot is that Hevesi, the trustee of the New York State Common Retirement Fund—which is the lead plaintiff in the WorldCom class action lawsuit—realized that the judge’s ruling could result in less money for the plaintiffs.
Hevesi, however, stressed that the judge did not rule against the personal payments by the settling directors and that is not the reason for the termination of the settlement. “The settlement is being terminated solely because of the potential impact on the amount other defendants might pay if the suit is successful," he added.
The directors will now rejoin the investment banks as defendants at a trial scheduled to start on February 28.
A Subtle Shift
Does this mean that directors can wipe their brow and not worry as much about their personal exposure? “I don’t think so,” asserts Peter Atkins, partner with Skadden Arps. “Based on why the settlement collapsed, it doesn’t say anything about future litigation settlements. I think there will be more of this.”
That’s not to say, however, that he expects a flood of agreements calling for directors to shell out their own money to settle lawsuits. That’s partially because the Enron and WorldCom collapses were unique in bankruptcy and corporate litigation history. “I would not read too much into these two cases,” Atkins asserts. “They are dramatic examples of perceived director oversight failures. But, I don’t expect more cases like that every day.”
“While the WorldCom, and to a lesser extent, the Enron settlement are sobering events for independent directors, the successful insistence by the plaintiffs in WorldCom that independent directors pay the settlement with personal assets is quite rare and certainly does not represent a pattern or trend,” says Steve Shappell, who leads the Aon Financial Services Group Legal and Claims Department, in a written analysis of the two settlements.
Not everyone agrees. “Although the WorldCom and Enron cases are aberrations that may be unique on many levels—and the exposure of the personal assets of faithless fiduciaries has always been a potential concern—the new trend is a practical concern,” writes E. Norman Veasey, who is none other than the former Chief Justice of Delaware.
Clifford Neimeth, senior M&A partner of Greenberg Traurig also senses a subtle shift underway. He says in the past two to three years, there have been more incidents of state fiduciary litigation being brought where the plaintiffs are pleading with specificity that the directors engaged in bad faith and breaches of loyalty.
This is a significant distinction. Neimeth explains that under state statutes, breaches of loyalty and acting in bad faith, as well as fraud and acting to benefit personal interests are all examples of actions that are not indemnified by the corporations for which they serve. In other words, in these instances, the directors find themselves more personally exposed. “Since there is no indemnification,” explains Neimeth, “they are directly held personally liable, so that could lead to settling earlier.”
Rare And Unusual
On the other hand, cases where it is proved that directors breached their duty of care are indemnified acts. Indeed, Aon’s Shappell asserts that the risk of a large non-indemnifiable claim has been foreseeable and is the compelling reason for most D&O insurance programs. So, in the future, directors should and will carefully review the existence and strength of indemnification agreements for board positions they hold.
In addition, directors will carefully review and scrutinize the amount, structure, and terms of the D&O insurance in place to protect their personal assets. “Having adequate limits of liability and a solid D&O insurance program with severability language to protect directors and officers would only have helped the independent directors by providing adequate proceeds to defend and protect themselves,” writes Shappell.
However, Elissa Sirovatka, who leads the D&O Liability Survey program at The Tillinghast business of Towers Perrin, doesn’t think D&O premiums will be impacted. “These are pretty unusual situations,” she adds. “That’s how the market looks at it. They won’t see it as a new trend.”
Indeed, Veasey points out that the time-honored business judgment rule is indeed alive and well under state law. Similarly, good faith and diligence should be a safe harbor under federal law. “Courts are not ratcheting up new pitfalls for conscientious directors,” he assures directors.
In fact, Veasey counsels directors to not be intimidated into settling and paying money to plaintiffs with shaky cases just to avoid an unlikely adverse court outcome. They should stay and fight. “Liability of directors is rare,” he adds. “Personal asset exposure of directors is rarer still.”