October 15, 2008

State Corporate Law Fallout from the Financial Bailout?

– by John Jenkins, Calfee, Halter & Griswold LLP

While the Treasury Department’s Troubled Assets Relief Program – know as “TARP” – does not directly address any state corporate law issues, if history is any guide, it’s probably a safe bet that this dramatic new federal initiative is going to have a significant influence on state law conceptions about what is necessary in order for a director to fulfill his or her fiduciary obligations.

One of the really interesting things about American federalism is the way that actions at the federal level influence what happens at the state level. When it comes to corporate law, the different results in two Delaware cases addressing the issue of director oversight decided a generation apart are perhaps the classic example of how federal actions influence state law requirements.

In Graham v. Allis Chalmers, 188 A.2d 125 (Del. 1963), the Delaware Suprme Court held that “absent cause for suspicion there is no duty upon directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.” While acknowledging that precedent, Chancellor Allen nevertheless decided in 1996 that a “director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists.” In re Caremark Derivative Litigation, 698 A.2d 959, 967 (Del. Ch. 1996):

What happened in between these two decisions? Most notably, the U.S. Sentencing Commission adopted organizational sentencing guidelines that provided strong incentives for companies to implement corporate compliance programs designed to detect and report violations of law.

More recently, we’ve seen Delaware and other courts grapple with the fallout from Sarbanes-Oxley and other federal reactions to the corporate scandals of the early part of this decade. Unlike the situation with the sentencing guidelines, the reaction by the Delaware courts to the corporate governance crisis was immediate and dramatic. During the first year after Sarbanes-Oxley’s passage, the Delaware Supreme Court addressed six cases involving alleged breaches of fiduciary duties by corporate directors, and the director defendants lost each and every one of them.

Since that time, directors have fared much better in the Delaware courts, but to this observer, it seems that those courts remain less willing to defer to board decisions and more willing to countenance plaintiffs’ allegations of director misconduct than they were in the past, at least during the early stages of litigation. The post Sarbanes-Oxley era has also seen the emergence of “good faith” based litigation, which has been the subject of two Delaware Supreme Court decisions (In re The Walt Disney Company Derivative Litigation and Stone v. Ritter) and which has produced this past summer’s most controversial chancery court decision. Ryan v. Lyondell Chemical Company, (Del. Ch., July 29, 2008).

How will TARP influence corporate law? At this point, it seems that the program could well result in changes in the way courts look at the board’s compensation decisions. Section 111 of the Emergency Economic Stablization Act of 2008 (the TARP program’s enabling legislation) imposes several compensation-related obligations on companies receiving federal assistance, including a prohibition on golden parachutes and an open-ended requirement obligating companies to impose limits on compensation that “exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution.”

What is intriguing about this provision is that much of corporate law, including bedrock concepts like the Business Judgment Rule, have developed in part to encourage companies to take risks, because that presumably is what equity holders want. Obviously, the situation is a little different in the context of troubled financial institutions receiving a massive infusion of taxpayer money, and the events of recent months make it very clear why Congress would want to require companies to focus on the relationship between corporate risk and executive incentives. Nevertheless, this kind of focus is a marked departure from the approach that corporate law has traditionally taken, and its implications could be quite profound if it influences how courts look at compensation decisions under corporate law generally.