Limited Liability: Corporate Directors Have As Much Chance of Being Sued As They Have of Being Struck By Lightning

With all the complaints emanating from Wall Street, the City and the upper reaches of global corporatocracy, one would think that the great-grandchildren of the Bolsheviks were storming the gates.

JPMorganChase CEO Jamie Dimon even had the temerity to suggest that America's faltering economy was due to excessive regulation. One had the sense that when the business and regulatory community had stopped roaring with laughter some of them might have contemplated asking him for the number of his pharmacologist.

The reality is that the world's wealthiest control a percentage of assets not seen since the 1890s. Regulation is faltering when it is not simply ignored. In any case involving commercial interests, the US Supreme Court led by Chief Justice Roberts has yet to find against business. In sum, this is a pretty good era for wealth and power.

Corporate directors, too, profess to be worried about their legal liability though as Steven Davidoff comments in the New York Times, they have literally as much chance of being sued for the consequences of mismanagement or poor decision-making as they have of being struck by lightning. There is nothing necessarily illegal about this. Unfair, arguably, but illegal, uh-uh. The problem is that it is economically unsustainable and one suspects we are going to have to learn that lesson the hard way. JL:

"They are paid millions, but some complain that it’s no longer worth it.

These men and women argue that, as corporate directors and officers, they have too much chance of liability for a company’s operations. Because of this, they claim, the risks of serving as a director or officer have become too great, and it will become harder to recruit and retain competent directors and officers. But the truth is that they have about the same chance of being held liable for their poor management of a public firm as they have of being struck by lightning.

The day-to-day management of a company is largely regulated by state law. Since most companies are incorporated in Delaware, this means Delaware law. And Delaware law on this matter sets an extremely high standard for finding directors and officers liable for a company’s mismanagement. A Delaware court is not going to find them liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.

Under this standard, a Delaware court recently refused to hold Citigroup’s board accountable for its decision to enter the subprime mortgage market, a decision that resulted in billions of dollars in losses and the company’s near failure. The boards of Bear Stearns and Lehman Brothers are also scot-free so far.

And only last week the board and management of Massey Energy won a case in Delaware Chancery Court that would make it significantly more difficult for them to be held liable for their ostensible poor oversight of the company’s safety practices that led to the Upper Big Branch mine explosion and the death of 29 men.

Even if there is liability or a settlement, it is almost always covered by insurance of directors and officers. One study found that from 1980 to 2006, there were only two instances of directors of a company incorporated in Delaware being required to personally pay for their misconduct.

One of those involved litigation against the board of Fuqua Enterprises. The Fuqua directors had the unfortunate luck to be insured by Reliance Enterprises, which went bankrupt. They paid an undisclosed portion of a $7 million settlement.

The other known personal-liability case involved the sale in 1980 of the TransUnion Corporation. The 10 TransUnion directors paid a total of $1.35 million. There you have it, no more than $8.35 million in personal payments by directors over more than 26 years.

There can also be liability for board members and executive managers under federal law. These are largely securities fraud cases where the directors or officers make a misstatement or omission.

This has nothing to do with the oversight of the company, but often there are misstatements about accounting or the company’s financial condition. Instances of personal liability for officers and directors in these cases are only a bit less rare, again because the standards are high and insurance often covers the matter.

The same study found only nine cases where a director was held personally liable for securities fraud in a 26-year period. Three of these were highly notable, Enron, WorldCom and Tyco.

And no directors from the financial crisis have yet been found liable under these laws. Officers are faring just as well, and the only prominent payment was by Angelo R. Mozilo of Countrywide Financial Corporation. He paid $22.5 million of a $73 million fine. The rest was paid by Bank of America. Meanwhile, the fines of David Sambol, Countrywide’s former president, and Eric P. Sieracki, the ex-chief financial officer, were paid in full by Bank of America.

The only financial crisis case to go to trial, involving officers of BankAtlantic, had its jury verdict finding civil liability overturned by the judge. And unlike with Enron and WorldCom, it seems there will be no criminal cases involving securities fraud stemming from the financial crisis.

What about the Dodd-Frank financial reform, you might ask? It doesn’t change much. The main provision concerning the personal liability of officers and directors involves systemically important financial institutions, or the “too big to fail” entities. And if one fails, Dodd-Frank authorizes the Federal Deposit Insurance Corporation to claw back two years of compensation from those held substantially responsible for the failure.

This is a weak penalty. An economically important bank with hundreds of billions of dollars in assets fails, and the penalty is only two years of pay? Nonetheless, the Securities Industry and Financial Markets Association and a number of other industry groups objected to the F.D.I.C.’s proposed rules on this requirement. The financial industry groups again argue that such a standard will drive away directors and officers as well as make it harder to recruit these people.

This is laughable. First, we’ve already seen that liability for boards and management is extremely rare. Moreover, many of the directors of Lehman and Bear Stearns continue to serve on other boards, and one Lehman director, Jerry A. Grundhofer, has apparently been so chastened about the liability issue surrounding large banks that he is serving on the Citigroup board.

More telling, there is no empirical evidence whatsoever supporting this argument. Instead, you have the occasional self-serving statements by officers and directors that they are resigning because of “liability” reasons. Officers in particular like to say that they are taking a company private for this reason. But more often than not, it is because there is more money in being private.

This is not to say that it has not become more difficult to be a director or officer. Regulation has certainly increased. So has scrutiny. This has made the work of being a director or officer of a public company harder and more time-consuming. And yes, if a company declares bankruptcy, these people will lose a lot of their investment and may in rare circumstances have to pay back some of their salary.

But is that too much to ask? According to a recent study by Equilar for The New York Times, the median salary of a chief executive at the top 200 major companies was $9.6 million last year. Salaries for chief financial officers at companies listed on the S.&P. 500-stock index shot up last year by 26.1 percent, according to Equilar, and the median salary is now $3 million.

The prominent law firm Wachtell, Lipton, Rosen & Katz recently issued a memorandum calling for director salaries to increase because of the increased burdens on this position. Outside director salaries average about $200,000 for Fortune 500 companies, according to Tower Watson.

The upside of serving as a director or officer thus appears huge. The downside is very limited. Yes, there will be increased regulation to comply with and some of it may even be unjustified, but that conflates liability with regulation. Remind directors and officers of this the next time they complain about the risk they are taking because of their jobs.