Academic journal article Stanford Law Review

Outside Director Liability

Academic journal article Stanford Law Review

Outside Director Liability

Article excerpt

INTRODUCTION
I. AN EMPIRICAL INVESTIGATION OF OUTSIDE DIRECTOR LIABILITY
    A. Trials: Frequency and Outcomes
    B. Out-of-Pocket Payments by Outside Directors in Settlements
    C. The Bottom Line
II. WHY IS OUT-OF-POCKET LIABILITY SO RARE? A LEGAL ANALYSIS OF
    SECURITIES AND CORPORATE SUITS
    A. The Scope of Out-of-Pocket Liability Risk if a Case Is Pursued
        to Judgment
        1. Securities lawsuits
        2. Corporate lawsuits--breach of fiduciary duty
        3. The resulting windows of out-of-pocket liability exposure
    B. The Effect of Settlement Incentives in Shareholder Suits
        1. Securities lawsuits
        2. Fiduciary duty suits
    C. Lead Plaintiff Motivated To "Send a Message".
        1. Solvent company
        2. Insolvent company
    D. The WorldCom and Enron Settlements: What Factors Allowed the
        Lead Plaintiffs To Extract Personal Payments?
        1. The WorldCom settlement
        2. The Enron settlement
III. OTHER POTENTIAL SOURCES OF OUTSIDE DIRECTOR LIABILITY
        A. SEC Enforcement Actions
        B. ERISA
CONCLUSION
APPENDIX A. SURVEY DESIGN
APPENDIX B. DETAILS OF SECURITIES AND CORPORATE LAW TRIALS
        A. Securities Law Trials
        B. Corporate Law Trials

INTRODUCTION

This Article analyzes outside director liability risk empirically, legally, and conceptually. Concern over liability for outside directors has arisen periodically since the 1970s, typically in response to specific events that appear to expose outside directors to heightened risk. (1) Outside director liability is again causing much concern, with the current trigger being the 2005 securities class action settlements involving WorldCom and Enron. In these settlements, outside directors agreed to make substantial payments out of their own pockets to settle securities class action lawsuits even though there was no evidence in either case that the outside directors knowingly participated in fraudulent activity.

The WorldCom securities class action arose out of the largest bankruptcy in U.S. history. (2) The company's twelve outside directors personally paid $24.75 million as part of a settlement with a plaintiff class led by the New York State Common Retirement Fund (NYSCRF). The Enron securities class action arose out of the second-largest bankruptcy in U.S. history; in this case, ten outside directors paid $13 million out of their own pockets to settle claims against them. In addition, the Enron outside directors paid $1.5 million to settle a suit by the U.S. Department of Labor (DoL) under the Employment Retirement Income Security Act (ERISA). In both settlements, the lead plaintiff insisted on personal payments by the outside directors. In announcing the WorldCom settlement, Alan Hevesi, the Comptroller of the State of New York and Trustee of the NYSCRF, stated that the payments were intended to send "a strong message to the directors of every publicly traded company that they must be vigilant guardians for the shareholders they represent.... We will hold them personally liable if they allow management of the companies on whose boards they sit to commit fraud." (3)

Press reports of the WorldCom and Enron settlements emphasized that they represented disturbing precedents for outside directors. For example, Richard Breeden, former chairman of the Securities and Exchange Commission (SEC), opined that the WorldCom deal "will send a shudder through boardrooms across America and has the potential to change the rules of the game." (4) Law firm client memos supported this view. (5) Many believe that lead plaintiffs in securities suits will follow the WorldCom and Enron script by seeking personal payments from outside directors as a condition of settlement and will succeed in extracting such payments.

Outside directors' anxiety about legal liability was high prior to the WorldCom and Enron settlements. The conventional wisdom was that being an outside director of a public company was risky. …

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