In recent years, there has been an explosion in the use of alternative entities such as limited liability companies, limited partnerships, and general partnerships (collectively referred to herein as “alternative entities”). In addition, limited liability companies have become the preferred vehicle for creating bankruptcy remote entities in many financing transactions, which may also feature mezzanine financing arrangements in which the equity interests in the limited liability company is the mezzanine secured party’s primary collateral. Therefore, it is imperative that commercial finance attorneys understand the consequences of using equity interests in alternative entities as collateral. Although practitioners may be inclined to treat equity interests in alternative entities the same as corporate stock, the provisions of the Uniform Commercial Code (UCC) relating to the use of equity interests in alternative entities as collateral are different from those relating to the use of corporate stock as collateral. Therefore, practitioners cannot approach the issue of perfecting a security interest in equity interests in alternative entities the same as he or she would approach perfection in corporate stock. This article will describe (1) the methods of perfecting a security interest in equity interests in alternative entities, (2) mistakes practitioners often make when using equity interests in alternative entities as collateral, and (3) a few helpful tips for practitioners to keep in mind when using equity interests in alternative entities as collateral. This article will primarily focus on the relevant UCC provisions related to using equity interests in alternative entities as collateral, but to the extent references are made to statutes governing alternative entities, it will refer to the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act. However, the concepts discussed will also have applicability in other jurisdictions, which might have similar statutes.
Basic Perfection Methods
In connection with any secured financing, the secured party’s counsel should first determine what type of collateral he or she is dealing with in order to determine how to perfect its security interest in such collateral. Unlike corporate stock, equity interests in an alternative entity may not always be the same type of collateral for purposes of the UCC. Equity interests in limited liability companies and partnerships can be a “general intangible” or “investment property.” UCC §§ 9-102(a)(49) and 9-102 (a)(42). Unless the alternative entity has taken affirmative steps to have its equity interests treated as “securities” for purposes of Article 8 of the UCC, such equity interests will probably be general intangibles. UCC § 8-103(c). Thus, a secured party must review the alternative entity’s governing document and certificate of interest, if any, to determine whether the subject alternative entity has opted in to Article 8 to have its equity interests treated as securities, in which case, such interests will be investment property, not general intangibles.
Once the secured party’s counsel has determined what type of collateral the equity interests are for UCC purposes, then he or she can determine how to perfect the secured party’s security interest in the collateral. If the equity interests are general intangibles, the sole method of perfection is by filing. UCC § 9-310(a). Therefore, if the equity interests are general intangibles, for priority purposes, the familiar rules of first to file will govern multiple interests in the equity interests. UCC § 9-322(a). To the extent the equity interests are “securities,” and therefore “investment property,” then the secured party’s counsel must determine whether such interests are “certificated securities” or “uncertificated securities.” If the equity interests are “certificated securities,” the secured party can perfect its interest by filing, control or possession. UCC §§ 9-312(a), 9-313(a), and 9-314(a). If the equity interests are uncertificated securities, a secured party can perfect by control or filing. UCC §§ 9-312(a) and 9-314(a). For purposes of priority, a security interest perfected by control has priority over a security interest held by a secured party that does not have control of the investment property. UCC § 9-328(l).
Common Mistakes
To recap briefly, equity interests in alternative entities can be “investment property” or “general intangibles” and the nature of the collateral will determine the permissible methods of perfection. This all seems relatively simple, but now let’s briefly describe some of the mistakes that practitioners make in dealing with this type of collateral. As an overarching premise, it is imperative that the practitioner appreciate that he or she is not dealing with corporate stock and therefore what might apply to corporate stock will not apply in the world of alternative entities. Thus, it will not be sufficient to simply follow the same procedures that such practitioner has followed to perfect an interest in corporate stock. For example, under Delaware law, in contrast to corporate stock, an equity interest in a limited partnership or a limited liability company is made up of distinct economic rights and governance rights, and the two sets of rights are not bound together by statute. Ultimately, a secured party will want to have the right, upon default, to take control of the equity interests, and have the ability to receive, or transfer, the economic benefits of the equity interest as well as the governance rights. Thus, it is critical for the secured party to adequately describe the collateral to ensure that the collateral description is broad enough to create a security interest in the economic and governance rights.
A practitioner should be careful about simply using terms like “membership interests,” “limited liability company interests,” or “partnership interests,” which may not be sufficient to encompass economic and governance rights. For example, under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, the terms “limited liability company interest” and “partnership interest” under the relevant act simply refers to a person’s right to share in the entity’s profits and losses and the right to receive distributions not governance rights. Delaware Limited Liability Company Act § 18-101(8) and Delaware Revised Uniform Limited Partnership Act § 17-101(13). Thus, a collateral description using the terms “limited liability company interest,” “partnership interest,” or “membership interest” to describe an equity interest in a Delaware entity would not be sufficient to include the governance rights in the secured party’s collateral. Therefore, a secured party that used such a collateral description might find itself with a security interest in the economic rights of such entity only and no ability to cause a distribution of the entity’s assets or to exercise any governance rights.
The second mistake we often see is a failure to perfect the security interest in a manner that provides the secured party with priority over other secured parties with a competing security interest in the collateral. The method of perfection depends on the type of collateral being perfected. Are the equity interests in the alternative entity “general intangibles” or “investment property”? If the equity interests are investment property, the secured party may perfect by filing, control, or possession, but a security interest perfected by control will have priority over a security interest held by a secured party that does not have control of the investment property. UCC § 9-328(l). Again, the mistake we often see here is a failure to realize that the collateral is “investment property” and the secured party’s failure to perfect its security interest by control or possession.
Some of the great benefits of Revised Article 9 are the self-help remedies that enable a secured party to take a number of actions without judicial assistance to realize the value of its collateral in order to satisfy the obligations secured by the security interest. Those self-help remedies include, but are not limited to, strict foreclosure, and selling or otherwise disposing of the collateral to a third party. UCC §§ 9-620 and 9-610. Thus, one of the other mistakes we see is a failure by secured parties to take advantage of the contractual flexibility inherent in most alternative entity statutes to protect its security interest and facilitate such self-help remedies. Furthermore, such a mistake is often compounded by practitioners using corporate stock pledge agreements as precedent and substituting member for shareholder and membership interests for shares, which without more will probably be insufficient to protect fully the interests of the secured party. Also, if practitioners simply follow corporate precedent, he or she may fail to use the entity’s governing document to enhance the secured party’s protection and facilitate many of the self-help remedies available under the UCC.
Thus, as will be described below, the secured party will want to make sure that the security agreement and the entity’s governing documents contain the necessary protections to allow the secured party to effectively, and efficiently, exercise the self-help remedies available to a secured party under the UCC.
Practical Tips
As a general matter, due to the contractual flexibility inherent in most alternative entity statutes, a secured party should take advantage of its ability to build additional protections into the subject entity’s governing documents, and not simply rely upon the representations, warranties, and covenants set forth in the security documents. For example, the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act each contain features that enable creditors to obtain additional rights and protections. Each act specifically permits the governing document to provide rights to a person that is not a party to the governing document. Delaware Limited Liability Company Act § 18-101(7) and Delaware Revised Uniform Limited Partnership Act § 17-101(12). Thus, counsel for the secured party should take steps to marry the contractual flexibility afforded by the alternative entity statutes to the favorable self-help remedies available under the UCC to ensure that the secured party will be able to realize the value of it equity interest collateral upon a default.
First, provide an adequate description of the collateral in connection with the creation of the security interest. Many alternative entity statutes, including Delaware, disaggregate economic rights from the governance rights provided to a holder of equity interests in the alternative entity. Therefore, the description of the collateral set forth in the security agreement that creates the interest must be broad enough to give the secured party a security interest not only in the economic rights but also the governance rights; otherwise if the description is not broad enough a secured party may find itself holding an interest solely in the economic rights that a debtor has in the alternative entities, similar to a charging order. Thus, the collateral description should make clear that it refers to the debtor’s governance rights under the governing document as well as the debtor’s economic rights.
Second, it cannot be emphasized enough: know your collateral. As mentioned above, a secured party should have a good understanding of what type of collateral the equity interests in the alternative entity are for purposes of the UCC. Thus, is the collateral a general intangible or investment property, and if investment property, is it certificated or uncertificated. Each of the foregoing conclusions will influence how a secured party perfects its security interest. In the event that the collateral is a general intangible, a secured party may want to request that the subject alternative entity actually opt-in to Article 8 of the UCC and perfect its security interest therein by control. Not only does opting in have the benefit of providing the secured party with a superior method of perfecting its interest, by control, but because the equity interests will be governed by Article 8, the secured party may in certain cases receive the benefits of being a “protected purchaser” and therefore actually receive an interest in the subject collateral that is superior to the interest of the debtor in such collateral because the secured party may take free of any adverse claims. UCC § 8-303(b). Opting in to Article 8 can be accomplished by executing a short amendment to the subject governing document, which expressly provides that the alternative entity’s equity interests will be governed by Article 8.
Related to knowing your collateral, it is also important that the secured party make sure that the subject collateral stays the same type of collateral after the security interest is perfected. Thus, in order to protect itself, the secured party should certainly build covenants into the security document, but also to the extent permitted by the applicable alternative entity statute, the secured party should hardwire protections into the alternative entity’s governing documents. Hence, a provision should be added to the governing document to prohibit the entity from amending the governing document to opt-in or opt-out of Article 8, as the case may be. Furthermore, for an entity governed by Delaware law, such entity can expressly provide in its governing document that the secured party must consent to any amendment that would change an equity interest’s status as a security or non-security.
Third, provide a mechanism in the documentation to permit the transfer of the equity interests and the admission by a transferee to the alternative entity. In order to fully take advantage of the self-help remedies available to a secured party under the UCC, a secured party should build a mechanism into the security agreement and the subject alternative entity’s governing document to permit the secured party or a third-party transferee of such equity interest to acquire the equity interests and to be admitted to the entity upon an event of default. This is a common pitfall for secured parties seeking to exercise self-help remedies. Unless the secured party takes steps to facilitate a transfer and automatic admission following a default by the debtor, a secured party may find that it is only able to acquire the economic rights under the equity interest. For example, under Delaware law, unless otherwise provided in the governing documents, the secured party’s admission to the alternative entity will require the cooperation of the debtor, and possibly the other equity holders, (Delaware Limited Liability Company Act § 18-301(b) and Delaware Revised Uniform Limited Partnership Act § 17-301(b)), and following a default, the debtor and the other equity holders may not be thrilled to assist the secured party with transferring the interest and admitting the transferee to the entity. Thus, in dealing with an alternative entity where admission is required to exercise governance rights, the parties may want to add a mechanism directly into the governing document whereby upon an event of default, the secured party will be automatically admitted to the entity, or alternatively, in some cases, a power of attorney can be granted to the secured party in order to facilitate such admission.
In addition, the secured party may require that the governing document contain language that structures the entity’s interests more like corporate stock, whereby a transferee succeeds to the transferor’s rights automatically upon transfer without further action on the part of the issuer or its equity holders. Under the Delaware statutes governing alternative entities, it is crucial to make sure that the admission issue is addressed if the entity only has one member or one limited partner because the transfer of the equity interest by the debtor to the secured party will cause the entity to dissolve because it has no members or limited partners. Delaware Limited Liability Company Act § 18-801(4) and Delaware Revised Uniform Limited Partnership Act § 17-801(4). That is the case because under the Delaware laws governing alternative entities, the debtor will cease to be a member or partner, as applicable, following the transfer of the interests and unless the governing document provides for an admission mechanism, the secured party or third-party transferee will not be admitted to the entity, which will cause the entity to lack the requisite partner or member needed to avoid dissolution.
Finally, due to the contractual nature of alternative entities, and particularly in Delaware, which expressly states that the policy of its alternative entity statutes is to give maximum effect to the principle of freedom of contract, the secured party should not merely rely upon the covenants and representations in the loan documents. Thus, instead of relying upon covenant defaults, protections may be added to the governing document that remove from the power and authority of the entity the ability to take certain actions that reduce, or might reduce, the secured party’s protection. As previously mentioned, the governing document should limit the entity’s ability to change the status of the collateral from a security to a non-security or vice versa, and it should prohibit amendments to the governing document that remove other secured party protections. In addition, the secured party may consider adding limitations on the power to issue additional equity interests or limit the authority to make distributions while obligations are outstanding. Thus, the secured parties should take advantage of the ability to enhance their protections in the alternative entity’s governing documents.
Conclusion
As the use of alternative entities increases, it is incumbent upon commercial finance attorneys to understand the characteristics of such interests and to ensure that they understand how to perfect such collateral, and otherwise deal with such collateral. Due to the flexibility of many of the alternative entity statutes and the contractual freedom available to the parties thereunder, care should be taken to ensure that a secured party sufficiently protects its security interest by taking some of, or at least considering, the actions described above. As stated at the beginning, the most important step in this process is to recognize that equity interests in alternative entities are not exactly like corporate stock and the approach by a secured party to protect its security interest in such collateral should be markedly different.
It is a widely held belief among institutional investors that custody accounts are protected against a bank’s insolvency in the United States. This assumption undergirds trillions of dollars of assets held in custody in U.S. banks. However, despite the 2008 financial crisis, little if any attention has been paid to analyzing whether this belief is, indeed, valid. This article argues that while the FDIC, as receiver of almost all failed banks in the United States, will likely protect custodied assets to the extent permitted by law, clients bear several significant legal and operational risks that could limit recovery of their custodied assets. While investors can protect against some risks, others may be outside their control. The article outlines these risks and proposes ameliorative steps for institutional investors.
It is an article of faith among institutional investors that assets held in custody are protected against a bank’s insolvency in the United States. It is such commonly accepted wisdom that there has been little, if any, analysis of the topic since the 2008 financial meltdown. This seems surprising when contrasted with the sudden, widespread focus on the risks of prime brokerage after the collapse of Bear Stearns and Lehman Brothers. This disparity would seem to confirm the accepted view among institutions that a custody account is the “safest place” for their assets.1
This article of faith undergirds the U.S. banking system. There are trillions of dollars of institutional investment assets held in United States custody accounts,2 and undoubtedly the assumption of most institutional investors is that if the bank fails, assets would remain theirs and beyond the reach of the bank’s creditors and general depositors. If this assumption were wrong, then the assets could be reduced—perhaps significantly—to satisfy the claims of those other parties. Loss of these assets could be cataclysmic for mutual funds, pension plans, hedge funds, endowments, and other depositor institutions,3 and needless to say, their clients and beneficiaries.
Along with this assumption is the notion that custodied assets will become available almost immediately for repossession by the investor, as contrasted with claim resolution in a bank’s insolvency proceedings, which might take years.
The attributes of custody are so widely recognized that since 2008 many hedge funds have moved their “net long” positions from prime brokerage to bank custody accounts,4 and similarly, since passage of the Dodd-Frank Act (“Dodd-Frank”),5 swap dealers and traders have explored holding margin or collateral in a custody account.6 Dodd-Frank itself imposes new custody requirements for investment advisory assets and futures collateral.7
Investors have good reason to trust bank custody. The Office of the Comptroller of the Currency (“OCC”) advises that “[a]ssets held by banks in a custodial capacity do not become assets or liabilities of the bank. . . . They are not subject to the claims of the bank’s creditors.”8 In addition, the American Bankers Association assures that “a failure of a bank will have no adverse effect on trust, fiduciary or custodial accounts: they remain the property of the account owner(s).”9
Thus, it is with good reason that bank custody is seen as best practice, and directors and officers of institutional investors may feel with confidence that they are properly discharging their fiduciary duties by entrusting assets with a bank custodian. If the financial community regards the sanctity of custody accounts as a truism, it is worth asking whether this assumption is, in a word, true. This is what this article sets out to do.
After surprisingly lengthy research, the answer is not simple. The challenges in understanding U.S. custody law start with the fact that “custody” is not usually a legal term of art, and while traditionally most analysis starts with common law concepts of trust, agency, and bailment, no one—including legislators, courts, and even the U.S. Federal Deposit Insurance Corporation (the “FDIC”)—applies them consistently or always accurately.10 (And slight differences in terminology can be significant. For example, while some states consider a custodial account to be a trust by operation of law,11 under federal law a custodial account is not a “fiduciary account” unless the custody bank provides investment advice or has investment discretion.12)
Next, consider the fact that the United States has a “dual banking system” of national and state banks, each with its own rules. While the FDIC typically acts as receiver of all insolvent banks, regardless of whether the bank is nationally or state chartered, it will apply federal or state law to insolvency issues depending on which set of laws governs the issue at hand. Then, to the extent the FDIC looks to state laws of custody, those laws not only vary across jurisdictions but the laws within a given state can be confusing. In this regard it is important to highlight Article 8 of the Uniform Commercial Code (the “U.C.C.”), as revised in the 1990s (“Article 8” or “Revised Article 8”), which overrides some common-law concepts of bank custody (as discussed further in Part IV). Additionally, while the topic of bank custody is broad, there is surprisingly little published guidance by courts or commentators. Along the same lines, many of the practices relating to bank custody are matters of “lore, not law,” and are not always fully disseminated by regulators or banks.
Indeed, there is little consistency among experts on what the law says, or even what the relevant law is. The written opinions of leading law firms addressing this topic are surprisingly scattered. Perhaps mindful of this, the outside counsel of at least one major custodian chose not to issue its advice as an opinion but rather as a “memorandum” in order, I assume, to avoid liability in the event of errors.13 In summary, then, this area of the law is, at the least, challenging.
If we move beyond these hurdles, as this article discusses in greater detail, apart from cash,14 assets held in bank custody in the United States should be protected from a bank’s insolvency by reason of strong, long-standing principles of the FDIC. But insofar as the FDIC implements relevant state law, state law can present its own challenges, which include U.C.C. Article 8. And then, turning from strictly issues of law, there is the “inevitable” risk of entrusting assets to any third party.15
There are at least four risks that can undercut if not eliminate the protections of a custody account. These are
Documentation Risk: The risk that the “custody agreement” fails to meet legal requirements.
Segregation Risk: The risk that the bank fails to segregate assets. This includes the risk that the bank fails properly to identify client assets internally or with securities depositories or other third parties.
Article 8 Risk: The risk under the rules of Article 8 of the U.C.C. that the client’s securities are not recoverable from bank assets in the event of the bank’s insolvency.
Bank Misconduct Risk: The risk of the negligence or misconduct of the bank as custodian (an even more acute concern in the wake of MF Global which, though not a bank, highlights the risk of negligence or misconduct by any financial institution to which assets are entrusted). 16This includes the risk that a bank misdirects assets borrowed from a custody account or improperly exercises the general lien that custody agreements typically grant custodians to assure payment of their fees and expenses.
As a lawyer working in the field of institutional investment, my impression is that many investors know nothing of these risks and assume that bank custody is in essence a guaranty: once an investor signs the custody agreement, the investor is automatically and fully protected. Investors are not entirely blameless on this front, as noted above.17
The rights of institutional investors in custody accounts are neither self-effective nor guaranteed as reliable sources seem to suggest.18 An investor cannot assume that its custody agreement will be recognized as such under law or that its assets will remain intact even if it has an effective agreement. Investors must actively guard their assets from loss arising from a custody bank’s insolvency. The loss of these assets is a frightful outcome for mutual funds, pension plans, hedge funds, endowments, and other institutional investors, but it is largely (but never completely) avoidable.
This article explores the laws of custody and how the FDIC protects the rights of custody clients in a bank’s insolvency.19 It then looks at U.C.C. Article 8 as it may challenge those rights. The article addresses some related topics and then closes with recommendations for investor best practice and conclusions.
A few notes on scope. First, as stated above, this article focuses on the insolvency rules of U.S. banks as they affect custodial assets of institutional investors. Largely beyond the purview here are insolvency rights of customers of U.S. or non-U.S. brokers or dealers, including prime brokers,20 or non-U.S. custodial banks. Along these lines, the article does not address custody rights under brokerage accounts, including rights under Rule 15c3-3,21 or broker-dealer rights in special deposits held in bank custody.22 Also, the article does not focus on custody rules relating to repurchase agreements, swaps, and other “Qualified Financial Contracts,”23 or accounts managed by a bank directly, including securities lending programs.24
I. OVERVIEW OF THE ISSUE; CUSTODY TODAY
The use of custodied accounts at U.S. banks has never been more important. As a result of the 2008 financial meltdown, and especially the Lehman failure, 25institutional investors have grown increasingly aware of their exposure to the creditworthiness of third parties who hold their assets. As many hedge funds and other investment firms discovered to their surprise four years ago, assets held with some offshore brokers, and specifically prime brokers in the United Kingdom, are not immediately available upon recall.26 Local rules, especially those permitting the brokers to rehypothecate27 customer securities, caught many of them unaware, and some were unable to immediately recall or move their securities to the United States, where stronger brokerage rules exist.
As market acuity increased, it became clear that the rules protecting brokerage accounts in the United States—the rules to which institutional investors flocked in 2008—are not as generous as those believed to protect bank custody accounts here. Under the Securities Investor Protection Act of 1970 (“SIPA”),28 brokerage clients stand as general creditors of the bankrupt firm to the extent that their losses exceed the amount insured by the SIPC, currently $500,000.29 When contrasted with the rules of bank custody as they are commonly understood, an elementary risk analysis demonstrates the appeal of bank custody over brokerage.
Bank custody offers one other advantage as well. While broker insolvencies proceed under either SIPA or the U.S. Bankruptcy Code,30 banks that are subject to the Federal Deposit Insurance Act (the “FDI Act”)31 are excluded from those rules. Instead, the FDIC acts as receiver32 not only for insolvent national banks but typically for insolvent state banks as well.33 FDIC receiverships are generally viewed as efficient and speedy, with the FDIC promptly returning custodied assets to the client or transferring them to the client’s designated successor custodian.34 Indeed, the FDIC has stated that it performs this function “automatically” without the need for any action by the bank.35 As the old adage goes, possession in this situation is surely nine-tenths of the law. Custodial assets are often transferred from the bank’s books before creditors have time, or the right, to object. 36Claimants must pursue administrative remedies against the FDIC as receiver before the FDIC can be sued in court.37 This means the custodied assets will be off of the bank’s books long before litigation ensues to bring them back. If this were not enough, the agency will trace and recover missing assets.38
But while the demand for custody accounts is on the upswing, and financial institutions are happy to offer accounts styled as “custody” accounts,39 it has become more difficult for some banks to agree to act as a fiduciary, one of the two pillars of custody as traditionally recognized in the United States and by the FDIC (the other pillar being segregation of assets, as discussed more fully below).40 The reasons for this include bank consolidation, which has reduced competition;41 client lawsuits regarding foreign exchange, which may have made some banks wary of their clients and more highly attuned to the burdens of custody, a traditionally lower risk business;42 and the overall financial climate after 2008 in which immoderate caution sometimes seems to prevail, even in traditional areas of banking such as custody.43
This heightened aversion to fiduciary undertakings appears grounded on the fear that the bank will be held responsible for the client’s investment decisions. It is true that status as fiduciary over custodied assets may imply broader fiduciary duties, such as investment discretion, as may be the case with accounts covered by the Employee Retirement Income Security Act (“ERISA”).44 But, as may be obvious for clients who are not subject to ERISA or other special regulatory requirements, a bank can delineate its role as fiduciary by contract and thus avoid liability for services expressly excluded. This is how some thoughtful custodians have addressed it.45
While banks may legitimately point out that the risk/benefits of the custody business today are not what they used to be, it is troubling to see a custody bank refuse to undertake requisite duties. This presents a trap for the unwary. 46As already noted, bank custody is widely known but little understood by institutional investors and others. In other words, while bank custody is something everyone thinks they understand, its foundations under law are unclear.
II. WHAT IS “CUSTODY”?
A. COMMON LAW SOURCES
At a recent presentation entitled “Observations on the Custody of Institutional Assets,”47 members of the American Bar Association’s Institutional Investors Committee were asked to guess which set of legal principles traditionally defines the relationship between custody bank and client: trustee and beneficiary; principal and agent; or bailor and bailee. Most hands remained motionless. Those who were reluctant to guess were either better or less informed than those who did, because the laws of trust, agency, and bailment have all been cited as the underpinning of custody.48 This is intriguing insofar as the three areas of law present inconsistent principles. Trust typically requires transfer of title to the trustee, while agency and bailment do not;49 trust and agency create fiduciary responsibilities while bailment does not;50 and a trustee typically is vested with broad decision-making authority, an agent has some defined area of action, and a bailee follows directions.51
The authorities are far from clear. For example, one treatise, speaking of custody accounts as “special deposits,” states:
A special deposit becomes such by specific direction or agreement to create a trust. . . . To create such a deposit, the bank must be made an agent or trustee, and agency or trusteeship cannot be created out of the mere external relationship of debtor and creditor unless the deposit is wrongful or the law forbids the bank becoming a debtor. . . . A special deposit is sometimes said to be equivalent to a bailment, but it is not always of that order. . . . Special or specific deposits are of a trust nature, and the relationship between the depositor and the bank is that of principal and agent or bailor and bailee.52
Even the FDIC has been inconsistent. It has opined at various times that the custodial relationship is a bailment,53 a directed agency,54 or a trust account.55
Adding to the murkiness here is the imprecision of the word “custody” under law. The term can be used to describe a specific legal relationship, as in the case of a custodian under the Uniform Transfers to Minors Act,56 or generically to describe the holding of a “thing,”57 but for the most part it is not used in statutes or cases. More typically, statutes either avoid specific terminology in favor of general descriptive language58 or employ another phrase, such as “fiduciary accounts,”59 while caselaw and treatises focus on the concept of “special accounts,” discussed further below. The point here is that a lawyer seeking to learn about this area of the law will discover that research of the term “custody” is generally fruitless.
Regardless of terminology, the common law found adequate legal basis to recognize that assets held in a properly formed custody account remain the property of the customer and escape the bank’s failure.60 The client placed securities and other valuables in the safekeeping of a bank, and the bank segregated those assets in its vault or a safe deposit box, and in return received a fee.61 Its duty was to protect the client’s assets as it would protect its own.62 This concept made sense in a preelectronic era when stocks, bonds, and other assets like jewels and deeds were physically stored in custody of a bank’s trust department. Even today, while the preponderance of assets in institutional accounts are securities held indirectly through a central depository such as the Depository Trust Company, custody banks continue to hold physical assets on behalf of institutional clients, such as gold bullion63 or, for example, original evidence of ownership of interests in real or personal property or synthetic instruments linked to property.64 (Such custody is called “on-premises” or “direct” custody. Custodial “possession” of the legal rights to assets located elsewhere, such as those held through a depository, is called “off-premises” or “indirect” custody.65)
B. STATE LAW AND “SPECIAL ACCOUNTS”
Courts have generally acknowledged a trust, agency, or bailment relationship in the case of “special accounts.”66 Special accounts are recognized under general powers granted to banks under state law.67 Custody accounts, as “special accounts,” denote assets distinguishable from the bank’s general assets and which will revert to the customer outside a bank’s insolvency.68 Courts have held that these assets not only pass outside insolvency but may be recoverable if wrongly transferred or converted; the OCC and the FDIC recognize this in the national banking context.69 (Query whether tracing of assets is permitted, or possible, for indirectly held securities.70) Arguably, then, a special account does not even form a “claim” subject to insolvency proceedings but rather is a contract right that passes outside the claims process.71 This is a sensible reading insofar as the FDIC, on the one hand, will convey custodial assets outside of an insolvency case but, on the other hand, is charged with treating claims ratably in the course of maximizing the insolvent estate.72
Because special accounts enjoy such extraordinary treatment, courts typically presume that all bank deposits are general assets73 and so a claimant must clearly show the parties’ intent to establish a special account in order to overcome the presumption.74 Courts have stated this imposes a “heavy” burden of proof 75 or that this burden can be “difficult.”76 No particular wording is required to evidence intent,77 but there must be clear evidence of a trust relationship,78 or an intent to segregate the assets for the client’s benefit.79 And, as further illustration of the inconsistent nomenclature used on this topic, the caselaw holds that simply calling or treating an account as a “custody account” does not mean it will be respected as a “special account” unless there is a convincing showing of a trust relationship.80 Parol evidence generally will not suffice,81 particularly as FDIC regulations require identification of accounts in the custodian’s records82 (and indeed, the FDIC has power to invalidate written contracts if it believes they are burdensome or not consistent with an orderly liquidation83).
Apart from the cases cited, there is little modern caselaw on the ownership rights of special accounts. This is probably because the FDIC so efficiently distributes custody assets from failed banks that generally there is no cause for litigation to arise later. Nonetheless, the cases demonstrate that the validity of a custody account requires clear evidence; that the assets are segregated in the client’s name; and that the elements of the custody account satisfy relevant legal standards. Thus, institutional investors should retain competent counsel to review the law and negotiate the custodial agreement, and should seek a legal opinion from the bank’s law firm confirming that the custody contract creates a valid and enforceable custody account (or “special” or “fiduciary” or “trust” account) under law.84
As noted, the FDIC will typically be the receiver of state bank insolvencies and will apply the relevant state law except to the extent that federal law is not inconsistent with state law or expressly preempts it.85 While a number of federal laws do preempt state law, and in recent years the Supreme Court has ruled on whether certain federal banking regulations are within federal banking power, 86I have found no federal laws that preempt the manner by which relevant state law would apply to custodial accounts in insolvency. Indeed, the FDIC has stated that it defers to state law on what constitutes a trust account at a state bank.87 Thus, it appears that state laws of custody should govern the FDIC’s actions as receiver of national banks as well as state banks.88 (Note, however, the distinction that suits involving the FDIC “are deemed to arise under federal law.”89) The relevant state law should be the law of the contract rather than the law of the state in which the account is located.90
C. NATIONAL BANKING LAWS
1. Substantive Law of Custody at National Banks
Under their general statutory powers, national banks may “receiv[e] deposits” and all other “incidental powers as shall be necessary to carry on the business of banking.”91 This language, found in 12 U.S.C. § 24, Seventh, is the font of federal law of custody for national banks,92 and reflects statutory intent to create the dual system of national and state banking discussed above. The dual banking system seeks equivalency, or an even playing field, between national and state banks, 93and therefore, presumably, a customer holding a custody account at a national bank will have the same rights in insolvency as a comparable client at a state bank across the street. Accordingly, like state banks, national banks may offer what the OCC calls “client-directed” custody accounts—in which the client or its investment advisers make investment decisions94—and “fiduciary accounts”— trust accounts authorized under section 92a of the FDI Act95—for which the custody bank delivers investment advice or makes investment decisions.96
The FDIC has furnished advisory opinions confirming that custodial assets will be excluded from a bank’s general assets in insolvency, and these opinions appear not to distinguish between client-directed accounts and trust accounts, or (as noted above) between state banks and national banks.97 However, one fairly recent advisory opinion is noteworthy because even though it responds to a question specifically about a trust account, it offers guidance that seems equally instructive to client-directed accounts. In that opinion, the FDIC advised that it is “well settled” that “the ‘general assets’ of [a] failed institution are subject to the claims of creditors but the ‘trust assets’ may be recoverable in full by the trust customers.”98 In this circumstance, the FDIC noted, holders of fiduciary accounts must
(1) establish the existence of a fiduciary relationship between themselves and the failed institution with respect to the assets; and (2) trace the assets into the hands of the institution’s receiver (i.e., the FDIC). The satisfaction of the first requirement will depend upon the terms of the agreement between the trust customer and the depository institution; the satisfaction of the second requirement will depend upon whether the depository institution—in accordance with this agreement—con-tinues to hold the asset (separate and apart from its general assets) at the time of the institution’s failure.
In most cases, the satisfaction of the requirements above will not be a problem. Indeed, the FDIC (as the failed institution’s receiver) will surrender the trust assets to the trust customers (or arrange for the holding of the trust assets by a substitute fiduciary) without requiring any action by the trust customers. Please note, however, that the FDIC cannot guarantee that every depository institution—after receiving or purchasing assets in a fiduciary capacity—will honor its obligations to handle these assets in an appropriate manner.99
Thus, it appears well established that the FDIC will assure a custodial account validly formed under state law will pass outside a bank’s insolvency, absent bank misconduct.
As noted in Part II.B., state laws of custody should govern at national banks. Insofar as U.C.C. remedies are matters of state, not federal, law, U.C.C. remedies may override state law protecting custodial assets to the extent the two sets of laws are inconsistent. See Part IV below.
2. The FDIC as Receiver
In a receivership, all claims against a failed bank “are fixed at the time of the declaration of insolvency,” and the FDIC “stands in the place of the bank.”100 The FDIC has only the rights that the bank had at insolvency, so that “the rights of third parties are not increased, diminished or varied” by receivership.101 However, as recognized in FDIC Advisory Opinion No. 03-01 cited above, the FDIC is authorized as receiver to avoid any fraudulent or other transfers before a bank’s insolvency.102 The potential loss of assets through negligence or fraud highlights the importance of continuing due diligence by clients, although it may be impossible for diligence to prevent it. As highlighted in the brokerage setting (e.g., MF Global), clients should not ignore the risk of a custodian negligently or otherwise depleting client assets immediately before insolvency. As suggested in Part VI, it is a good idea to have a second custodial relationship in place in case there is enough time to heed warning signs of a bank’s failure. It is important to note again here that the U.C.C. may override marshaling claims, especially if the bank can lend assets or has a lien for fees as typically granted under a custody agreement. Sometimes the lien covers all custodied assets or only enough assets to secure the amount of fees it is owed from time to time. In any event, Article 8 raises questions whether the client would later recover securities that the bank transferred out of the custody account’s records pursuant to lending rights or a lien (or otherwise).103
D. CONCLUSION
In sum, the most important protection for institutional custody clients is the FDIC acting as receiver. The OCC and the FDIC each has stated a clear intent to respect custody accounts that satisfy legal prerequisites unless the bank failed to “honor its obligations to handle these assets in an appropriate manner.”104 Thus, the FDIC’s decision to release custody assets “immediately”105 will be para-mount,106 although it remains unclear whether it will honor U.C.C. Article 8 and not seek tracing of assets lost to the client under Article 8, even though the FDIC has the right to do so. The issue may be moot, however, insofar as the drafters of Revised Article 8 have observed that tracing of indirectly held securities is neither possible nor economically desirable following a financial intermediary’s insolvency.107
Two other questions come to mind here.
What if the bank fails to hold custody assets in “trust”? This is a real-life problem, in my experience, because as noted some custodians resist assuming fiduciary duties as custodian,108 either perhaps out of fear of fiduciary liability109 or the belief that fiduciary status is not required by law.110 The answer here is that it should be irrelevant whether the account is styled as a “trust” account so long as the bank assumes fiduciary duties and agrees to segregate assets, and takes any other additional steps as may be required by relevant state law so that the client can clearly demonstrate the existence of the custodial relationship.111
What if the client discovers that the assets are held outside the trust department of a national bank? The FDI Act defines “deposits” to include funds held in a fiduciary capacity, whether held in the trust department or any other department of a bank or savings association.112 The FDIC’s Trust Examination Manual confirms that custodial accounts need not be maintained by a trust department.113 So here it would appear that the FDIC as receiver would apply its rules to custodied assets held outside a trust department.
Again, the OCC and the FDIC treat custodial assets as client property which is to be passed back to the client in the event of a bank’s insolvency. Where there is no clear statutory confirmation, the FDIC’s position should be given “considerable weight.”114
III. SOME WORDS ON CASH AND STIF AND MONEY MARKET FUNDS
Savings, checking, and CD accounts are typically treated as general assets of a bank and are not afforded the protections of the custody account.115 However, FDIC insurance would cover up to $250,000 of cash assets held at an FDIC-insured bank.116 This explains a recent report that a hedge fund deposited approximately $249,000 in cash with several hundred different banks.117 (Note that the FDIC is temporarily offering unlimited insurance on non-interest bearing accounts.118)
FDIC insurance covers all “insured deposits,” or deposits for which there is a net amount due to the depositor.119 Under the statute, unpaid deposits include not only cash but checking, savings, time or thrift accounts, and certificates of deposit.120 However, the FDIC has opined that U.S. Treasury securities are not “cash” and therefore can be part of a custody account.121
Despite the general rule on cash and cash equivalents, in some states they may be considered part of the custodial account. One test can be whether the obligation bears interest.122 According to the 2003 Merrill Lynch case,123 New York law provides that a special deposit can include money and cash equivalents, and that:
The fact that the Custodial Account was, or could have been, a time deposit or demand account, interest bearing, or a business checking account is not material and does not affect the determination that the Custodial Account was a special deposit. The form of the account (checking, interest-bearing, etc.) does not matter. The critical point is whether a bank and a depositor have agreed that an account is to be a special deposit or not. (“A certificate of deposit can be either a general or special deposit, depending on the agreement between the bank and the depositor.”)124
Oftentimes an institutional investor’s cash resides in a short-term cash (also called “STIF”) account. Although STIF funds are not FDIC-insured, they should be protected from bank insolvency as a collective investment fund (“CIF”) under the OCC fiduciary rules established under 12 C.F.R. § 9.18.125
However, contrary to popular wisdom, money market funds are not governmentinsured, although if held through a brokerage firm then SIPC insurance should cover balances of up to the $250,000/$500,000 limit discussed earlier. 126In this regard, it is worth noting that some brokers offer institutional clients supple-mental insurance above SIPC limits through third parties such as Lloyds.127 I am not aware of banks offering something similar to custody clients, but needless to say the value of any such insurance will depend not only on the coverage amounts and other terms and conditions but the continuing creditworthiness of the insurer.
IV. U.C.C. ARTICLE 8 AND “SECURITY ENTITLEMENTS”—A THREAT TO THE TRADITIONAL LAWS OF CUSTODY?
A. OVERVIEW
Article 8 of the U.C.C., as amended in the 1990s, imposes a significant limitation on custody rights. Custody clients, as “entitlement holders,” no longer own securities held at a securities depository but rather possess “security entitlements” against the bank as a “securities intermediary.”128 Imposed between the custody account and the securities lie the concepts of “vertical priority” and “horizontal priority”129—the claims of other investors and the claims of the bank’s creditors.
Revised Article 8 addresses “systemic risk”130 arising from the meteoric acceleration of securities trading and clearing via electronic platforms and the shift from direct custody of securities at a custodian to indirect holding through a depository, and the modern interbank lending system in which banks lend to, and take credit from, other banks.
As noted by the drafters of Revised Article 8, the earlier Article 8 provided antiquated rules in which physical possession of securities was the norm.131 In that era, security interests in securities were perfected by possession. That template needed to be modernized to address electronic trading and the fact that while custodians continue to keep records of their clients’ securities holdings, those holdings often are held elsewhere, e.g., at a central depository such as Depository Trust Company.
Unfortunately, as Article 8 deals with the complicated issues of securities clearance and bank lending, it is also one of the most difficult areas of the U.C.C. to understand, being described by the official reporter of Revised Article 8 (certainly a sympathetic observer) as “recondite.”132 This is regrettable, because its impact is so important and (as best as I can tell) not understood by many institutional investors.
It is also problematic as it applies to traditional rules of bank custody. On the one hand, a goal of Article 8 is to create a system for record keeping 133and, therefore, is meant to effect no substantive change of creditor rights. 134Indeed, Revised Article 8 recognizes, as stated in the Official Comments to
Article 8, “the ordinary understanding that securities that a firm holds for its customers are not general assets of the firm subject to the claims of creditors.”135 But Revised Article 8, on the other hand, by changing ownership interests in securities to entitlement claims against securities intermediaries, supplants the common law of bailment and is deemed the exclusive source for claims relating to securities.136 Thus, it would appear that Article 8 overrides any conflicting law regarding claims to securities by custodial clients.
Relevant defined terms in Article 8 include “securities intermediary,” which includes banks, brokers, and, notably, clearing corporations;137 “entitlement holder,” which is a person identified in the securities intermediary’s records as having a security entitlement against the securities intermediary;138 and “security entitlement,” which comprises the rights and property interest of an entitlement holder with respect to a financial asset.139 These terms are essential units of Article 8’s treatment of securities, whether certificated or uncertificated,140 and whether held in the bank (called on-premises custody) or through a clearing-house or other intermediary (off-premises custody).141
Another term, “control,”142 is key to understanding the rights of custodial clients in the event of competing claims to a security entitlement.143 A purchaser 144has “control” of a security entitlement if (i) it has become the entitlement holder, that is, the purchaser is recorded in the records of the securities intermediary as having a security entitlement,145 (ii) a securities intermediary has agreed to hold the relevant asset for the purchaser, or (iii) a third party has control of the asset on behalf of the purchaser or previously obtained control and has acknowledged that it holds the asset on behalf of the purchaser.146 With “control,” the controlling party is in a position to sell or transfer the security entitlement without further action by another party.147 So, hypothetically, if a custody bank takes control of a security entitlement pursuant to a lien it was granted by the client or otherwise, and then the custody bank sells or transfers the security entitlement to an innocent third party or a bank creditor, then, if the bank becomes insolvent, the question is whether the lower priority claimant—i.e., the custodial client—has means of recovering the asset to which the entitlement claim is affixed. Here, there is a conflict between Article 8, which does not permit tracing of lost securities (except for fraud),148 and the FDIC’s rules, which do.149 This is discussed below.
B. SECURITY ENTITLEMENTS AND WAYS TO LOSE THEM
A custodial client acquires a security entitlement, and thereby enjoys the rights of an entitlement holder, in one of three ways: the bank (securities intermediary) credits the asset as a book entry to the client’s account; the bank accepts the asset for the client’s account; or the bank is legally obligated to credit the asset to the client’s account.150 As noted, the foregoing applies regardless of whether the bank physically holds the asset, so the rules also apply to securities held through a depository.151
So far, then, simply put, the custodial client has an entitlement claim to its securities holdings, and therefore the claim should remain with the client in the event of the bank’s insolvency, so that, for example, the securities on record in the custodian’s books will be transferred to the books of the client’s successor custodian.
There are exceptions to the general rule of security entitlements set forth above. One exception is akin to the concept of the “holder in due course” found elsewhere in the U.C.C.152 Here the entitlement holder may recover a financial asset from a purchaser who acquired it “for value” and “controls” the asset only if (i) the now-insolvent securities intermediary lacks sufficient assets to restore the security entitlements of all entitlement holders, (ii) the securities intermediary violated its duties under section 8-504 by transferring the asset, and (iii) the purchaser acted “in collusion” with the securities intermediary. 153In other words, whether the loss occurred by mistake or otherwise, the custodial account cannot recover a security previously documented in its records at the custodian bank so long as the current holder of the security entitlement did not collude with the bank. Thus, as noted, Article 8 introduces what can be described as the concept of “horizontal priority.” Without collusion, the custody client enjoys no priority over innocent investors who have acquired the rights to the client’s securities claims. This explains in part why Article 8 rejects tracing of assets—in addition to Article 8’s premise that a security entitlement is not a claim against a specific security but against the assets of the financial intermediary, tracing not only would pit one innocent party against another but would subvert the crucial goal of assuring market participants that the securities they buy are free of prior competing claims.
A related exception, in section 8-511(b), applies to bank creditors, or the rule of “vertical priority.” If a bank creditor has a claim to a financial asset held by the bank and “controls” the asset, the creditor’s rights will prevail over a custodial client who has a claim to the same asset. So if, say, a bank transfers a financial asset from a custodian account to a bank creditor,154 then the creditor’s claim is superior, notwithstanding the client’s contractual rights under a valid custody agreement, or even the client’s vigilance (recognizing that clients may not have access to real-time transactions), unless it can be proven that the bank’s creditor colluded with the bank. While the U.C.C. requires good faith in all transactions,155 query whether the transfer of a financial asset to a creditor of a now insolvent bank will be unwound if the bank acted other than in good faith but did not actually collude with the creditor.156 Under my reading of Article 8 and especially its no-tracing rule, the answer is that it will not. The result, then, would appear to be a case of Article 8 trumping the common law of custody and bailment (as intended by the drafters of Article 8157) and, for that matter, federal banking regulation as implemented by the FDIC.
The result, in the case of a failed bank, is that the custodial client has a pro rata interest in the relevant security158 under insolvency proceedings.159 This pro rata right may not be to recover the account shortfall for a relevant security but, depending on relevant insolvency laws, a right to a portion of the bank’s available assets based on the value of the client’s claims measured as a percentage of all claims against the debtor bank.160 The Official Comments to Article 8 suggest that this may be relevant for broker insolvencies under SIPA, and I am not aware of state or other insolvency laws that would follow the SIPA approach. If there are laws that do, then if the estate of an insolvent bank lacks sufficient security entitlements in, say, Stocks A, B, and C, to satisfy client claims, while still retaining 100 percent of the security entitlements for Stocks X, Y, and Z, all of its clients would bear a proportionate loss arising from the A, B, and C shortfall, even those clients who may have felt fortunate because their only claims were for Stocks X, Y, and Z. Contrast this with how customary FDIC rules would allow those clients to keep their 100 percent positions in Stocks X, Y, and Z. This example highlights the question of remedies for securities shortfalls under Revised Article 8.
As the Article 8 drafters noted, asset tracing is inapposite, even if it were fea-sible.161 To this extent, Article 8 would appear to override the FDIC’s duty to marshal assets for custody accounts. In this sense, Article 8 seems inconsistent with the recognized principle—whether called preference avoidance under bankruptcy law or the D’Oench Duhme doctrine as recently expanded under bank insolvency law162—that assets that are improperly transferred proximate to a firm’s failure may be restored to their rightful owners. There could be a tort claim in this circumstance,163 but a tort claim may be of little value when the bank-tortfeasor is insolvent.
C. CHOICE OF LAW
Article 8 applies the relevant laws of insolvency.164 As noted, the FDIC will apply state laws of insolvency to state banks and, to the extent not inconsistent with federal law, to national banks. But even state law may be uncertain as to how custodial accounts are to be treated in insolvency. For example, one prominent law firm has stated that the banking statutes of Massachusetts do not address how custody accounts are treated in insolvency, and believes that the common law of bailment would be applied.165
D. CONCLUSION
Now that I have painted this gloomy picture, I should point out that many banking law experts say that there is no reason for custody clients to be concerned about Article 8. They point out that segregation of client assets is an essential duty of banks that is faithfully discharged, and there is no basis to question whether any bank in the institutional custody business does not fulfill its duties in this regard. But in a post-2008, post-MF Global environment, I worry nonetheless whether in the future a bank could make a mistake, or worse, when there is no time to remedy the problem before insolvency, and leave the custodial client with Article 8 remedies to the extent they displace FDIC regulations. It has been noted that Revised Article 8 “does not, nor could it, eliminate theft risk, that is, the risk that an intermediary will dispose of securities that should have been for customers and abscond with or dissipate the proceeds.”166 Indeed, insofar as the risk of theft of financial assets is inevitable,167 the FDIC has advised that it “cannot guarantee that every depository institution—after receiving or purchasing assets in a fiduciary capacity— will honor its obligations to handle these assets in an appropriate manner.” 168So while I hope this discussion remains purely theoretical, it is important for custody clients and their legal advisors to make their own analyses, draw their own conclusions, and consider how best to protect their holdings.169
As noted, despite the analogy discussed above, Article 8 is not strictly a record-keeping statute. It supersedes the common law of custody, and specifically it places a custodial client as a general creditor of an insolvent bank with respect to financial assets that were removed from its account either by bank error or malfeasance. To this extent, the bank is not a “mere recordkeeper” but rather an interested party.
It would seem, then, that institutional investors must remain vigilant as circumstance permits in overseeing all intermediaries, including bank custodians, and have alternative arrangements in place if the bank or other intermediary seems to be near failure.
V. A NOTE ON FOREIGN SUBCUSTODY
Foreign custody is outside the scope of this article.170 Needless to say, however, as institutional investment becomes increasingly multinational, with emerging and frontier markets posing particularly challenging custody issues, foreign custody may be a concern of many U.S. institutional investors. While in the past a U.S. custodian would typically agree to stand behind all activities of foreign subcustodians, including the duty to segregate assets and to indemnify the client for all losses, today’s custody agreements often offer less protection. In my experience, custodians now may offer to apply due care in the selection and monitoring of foreign subcustodians and a limited guaranty for subcustodian negligence or willful misconduct (but not for losses from insolvency).
Contrast this, however, with the foreign custody protections afforded to investment companies under the Investment Company Act of 1940 (the “Company Act”).171 In my experience custodians do not offer these rights to non-investment companies. This is important because the Company Act requires, among other things, standards of quality for subcustody banks, as well as requirements that:
The foreign subcustodian assume a standard of “reasonable care, prudence and diligence such as [the U.S. custody bank] would exercise, or to adhere to a higher standard of care, in performing the delegated responsibilities”;172 and
The subcustody contract provide, among other things, that (1) records identify the assets as belonging to the client or a third party for the benefit of the client, (2) there is adequate indemnification against risk of loss of subcustodied assets, (3) no liens may be created against the subcustodied assets, and (4) the subcustodian report developments relating to the safe-guarding of the assets and any transfers thereof.173
State rules also may hold the custodian to a higher standard than that it might otherwise be willing to agree to under a custody agreement.174
VI. RECOMMENDATIONS FOR INSTITUTIONAL INVESTORS
As discussed, institutional investors too often incorrectly assume that custody is a guarantee of safety.
The risks discussed in this article can be ameliorated (but not necessarily eliminated) by pre-retention due diligence, contractual terms, post-retention due diligence, and extra-contractual protections.
A discussion of each of these topics follows.
PRE-RETENTION DUE DILIGENCE
Before retention, consider the following diligence items. Outside counsel can assist with analyzing the governing law to confirm that it protects custodial assets as anticipated.
Initial legal due diligence issues include
Which specific entity in the banking institution’s cadre of affiliates will be the custodian?
Confirm the custodian is an insured depository institution under the FDI Act.
Confirm the contract correctly identifies the custodian entity.
Is the custodian properly authorized to hold custody assets? This would mean the bank has a trust department, if state law requires it. In the case of fiduciary accounts at national banks, has the custodian been approved to provide trust services?
Ask for the form of legal opinion that the custodian’s outside law firm will furnish as part of the contractual documentation. Is it a “clean” opinion with only appropriate exceptions and limitations?
For example, if the opinion assumes a valid claim so long as the custody agreement grants the bank no right to any lien on custodial assets, make sure the agreement prohibits such liens.
On the business side, due diligence issues include
Does the custodian have an adequate credit rating? If not, will a deep pocket affiliate guaranty its indemnity and other obligations to the client?
What are the spreads on the bank’s credit default swaps (“CDS”)? Some analysts use CDS spreads as another piece of data to evaluate a firm’s creditworthiness.
Does the custodian meet the requirements of being “well capitalized” 175 and “well managed”176 under banking regulations?
What are the custodian’s practices regarding segregation and identification of client assets? What safeguards are in place to prevent improper transfer of client assets recorded on the depository’s books to the bank’s proprietary accounts? Ask to see the custodian’s internal controls materials.
Where does the custodian sit in terms of interbank lending? clearing?
How does the custodian assure that all accounts are fully credited on securities transactions? Are there many mistakes and how quickly are they corrected?
Does the custodian intend to borrow against custody assets and will it seek a lien on assets, such as a lien to ensure payment of custody fees?
Are any issues raised by the custodian’s SAS 70?
How does the custodian pick and monitor foreign subcustodians? To what extent does it track the solvency of foreign subcustodians, and does it have in place appropriate alternatives if it needs to transfer those assets quickly?
Are there directly held securities that the client could maintain in custody without affecting trading?
Be sure to address the resolution of all business issues in the custody agreement.
As part of the first stage of diligence, speak to the bank’s other institutional clients. If none are known, get names from the bank. Ask these clients about the topics noted above and specifically ongoing monitoring issues such as the custodian’s compliance with segregation and proper account identification; client access to bank records to confirm daily reconciliations; and the quality of and access to reports from foreign subcustody banks. More generally, it is worth inquiring about the custodian’s attentiveness to clients; the amount of red tape it requires; and to what extent the client service team can make red tape disappear.
Also, on the assumption that strong compliance generally cannot thrive without a top-down commitment, speak to senior management and the executives who are responsible for key elements of the custodial business.
CONTRACTUAL TERMS
As noted, apply the knowledge learned in due diligence to the custody agreement. For example, if the custodian’s foreign subcustody practices are good, seek to incorporate them as covenants. Combine items learned in diligence with advice of outside counsel expert in the relevant custody laws. While using counsel’s template is advantageous, the bank might want to use its own form.177 This can add to the volume of comments from client counsel (as well as raise counsel fees). As already discussed, negotiating appropriate terms from a custodian in 2012 is not for the faint-hearted. It may require hard work.
Among the terms to be addressed in a custody agreement would be the following:
The custody agreement is with the proper bank entity.
Due authority—specifically, the bank is duly authorized to furnish custody of assets.
As noted, the bank may be required to have a trust department and to manage the custody account at the trust department.
The agreement clearly establishes the requisite legal relationship between the custodian bank and the investor. Ordinarily this would include an explicit fiduciary or trust relationship.
For client-directed accounts, there can be appropriate carve-outs to assure the bank is not somehow assuming investment discretion or other regulatory duties that are irrelevant to the client.
The bank will segregate the investor’s assets and keep records in the client’s name.
If the bank is not permitted to borrow any custody assets (in other words, no securities lending), say so explicitly to avoid any misunderstanding later.
The bank will place no liens against the custodial assets, even to the limited extent to secure the bank’s fees.
The bank’s template agreement often will include an unlimited lien on assets, but on request the bank should agree to limit the lien only to cover the amount of custody fees outstanding at any given time. In light of U.C.C. Article 8 risk, in lieu of any lien, a better course might be for the investor to furnish a separate guarantee letter with re-course (if any) only to non-custodied assets.
Although many custody agreements require thirty to ninety days’ notice prior to termination, the agreement could allow the client to move its assets to another custodian at any time for any reason. It is hard to imagine the custodian objecting to this so long as the contract adequately addresses the payment of its fees on termination.
Consider seeking the full measure of foreign subcustody rights as those afforded to investment companies under the Company Act. In any event, it would seem appropriate for the custodian to undertake:
To require each subcustodian to assume the same standard of care as what the custodian owes the client;
To confirm that each subcustodian satisfies the requirements of being an “eligible foreign subcustodian” under the Act;
To monitor regularly each subcustodian, and promptly notify the client of any material change in these risks; and ultimately
If the custodian reasonably believes that a subcustodian is at risk or otherwise no longer satisfies the requirements of being an “eligible foreign subcustodian,” to withdraw client assets from the subcustodian as soon as reasonably practicable and deposit them with a successor subcustodian under equal if not better terms.
Cash management should be addressed. If cash is invested in a STIF or money market fund, confirm whether the cash can be withdrawn daily or on short notice.
Ask for annual or quarterly certification that the account is being held and documented in accordance with the agreement. Seek audit rights regarding segregation, account names, and the timeliness and effectiveness of securities accounting. If the bank will not agree, ask for regular up-dates of the SAS 70 and/or the appointment of an independent firm to conduct a regular audit for the benefit of all custodial clients. (The bank may come to appreciate the insights this firm could offer, especially if by allowing the firm to visit, the bank can eliminate the distraction of responding to many more auditors representing a variety of clients.) As-suming the bank is subject to Dodd-Frank’s “living will” requirements, 178ask for copies of the bank’s resolution plan or at least the sections dealing with material developments.
Ask the bank for a written opinion of its outside counsel that, subject to acceptable exceptions and qualifications, the custodied assets will pass to the client or its successor bank outside the custodian bank’s insolvency.
POST-RETENTION DUE DILIGENCE
Post-retention due diligence is of at least equal importance as pre-contract diligence since rights of custody are not self-effective. As noted, the bank’s actions or inactions, and those of its foreign subcustodians, can undo custodial rights.
Post-retention due diligence issues may include
Continual monitoring of financial statements, credit ratings, CDS spreads, and capitalization tests, including the living will resolution plan, if relevant, not just of the custodian but of all of its affiliates.
The issue here is the contagion effect. In the Lehman Brothers case, only several Lehman companies actually filed for bankruptcy.
This includes information about the resolution plan under Dodd-Frank, if relevant.
Regularly review accounts to confirm segregation and account names, and prompt and correct settlement of open securities positions.
Monitor and enforce rights obtained under the custody agreement, such as periodic bank certifications. Exercise audit rights.
Review SAS 70s and all other audit-related information to which one is entitled.
Regularly meet with the bankers responsible for safekeeping and accounting of custodial assets.
As noted above, clients may consider hiring an outside auditor or consultant to help monitor the bank’s processes.
EXTRA-CONTRACTUAL PROTECTIONS
If it is valid that the client should treat its custodian like any of its other unsecured counterparties, then the client may wish to consider several additional avenues of protection.
Set up at least one additional custodial relationship. By having multiple custodians, the client has the flexibility to move assets, promptly if necessary, without having to negotiate a new custody agreement at the last minute. As with the initial custodian, conduct diligence. If it is best practice for hedge funds to have multiple prime brokers to avoid insolvency risk, then the same principle should apply to custody.
There appears to be a trend of some U.S. institutions to establish at least a second custody relationship offshore, e.g., Canada (a country that has experienced no recent banking crisis similar to that in the United States). It could well be that offshore custody may offer clearer laws and a strong commitment to their custodial clients. But this may be of limited utility to the extent foreign banks must use U.S. banks as their subcustodians of U.S. securities.
Consider hedging exposure against the bank’s failure via shorts or options. Some newer financial products are specifically targeted to protect against credit exposure.179 Perhaps buying CDS protection may also be worth exploring, although the costs can be high and legal impediments may exist in various jurisdictions. In this regard, many experts believe that “naked CDS,” that is, the buying of short (protection) CDS without an underlying ownership of the reference bank’s bonds or other debt— will be prohibited or significantly restrained.
I do not know if custodial insurance exists now, but if not there could be a market for it.
Perhaps while impractical in most situations, there may be particular securities that an investor can hold through a physical certificate without making trading cumbersome. This may be relevant, for example, if an investor has a significant equity position in a particular company that it intends to hold long-term.180
As a final thought on this topic, it is sad to say that in the post-2008 world of MF Global, LIBOR price rigging, and other events yet to come, even all of these precautions, diligently pursued, may not be enough to prevent loss arising from intermediary misfeasance or malfeasance, especially acts occurring at the last minute before insolvency.
VII. CONCLUSION
The law of custody is diffuse and inexact. Consider the following points noted in this article:
There is no standard term used to describe custody accounts, and indeed “custody” is generally not a legal term of art.
The common law of custody is imprecise, and traditionally courts analyzing the existence of “special accounts” have not consistently answered the question whether the underlying principle of law supporting custody accounts is trust, agency, or bailment.
The FDIC acts as receiver for almost all bank insolvencies in the United States, and while it is charged with following state law for state bank insolvencies, the state laws of custody can be uncertain, and it does not appear that Congress has adopted a federal law of custody in respect to national bank insolvencies, leading the FDIC and courts to point to state law.
Courts require proper evidence of a custody relationship as determined under relevant law. This may require not only the presence of something called a “custody agreement” but also fiduciary or trust undertakings by the custodian and an affirmative covenant to segregate client assets.
Revised Article 8 of the U.C.C. overrides traditional custody law by turning an absolute right to assets into a claim, and for electronically traded securities held at a central depository, the claim may fail to the extent the client’s securities (or, more accurately, the client’s security entitlements) were transferred to an innocent third party, whether by mistake or mis-appropriation. While the FDIC will seek to marshal custodial assets the tracing of indirectly held securities is no longer apposite under Article 8. Thus, unlike an action in bankruptcy to recover an asset by avoiding a preference transaction, or the tracing of a security certificate that a custodian lost or wrongly converted, the risk of loss arising from the improper transfer of electronically traded securities under Article 8 is irreversible, assuming the estate of the insolvent bank has no assets to cover them. If this is indeed the result, the law seems to offer the custody client no analogous right to undo what a bankruptcy trustee is empowered to correct or, for that matter, the FDIC may cure in other situations. I find it hard to square this outcome with statements in the Official Comments that Article 8 makes no substantive changes in the law and may be likened generally to a real estate recording act. While a local government real estate office should have no vested interest in making sure that deeds, mortgages, and other liens are properly recorded, securities intermediaries such as custody banks may have a lien or other right to client assets (such as securities lending), and unlike a government office a bank can go out of business suddenly without the opportunity to correct mistakes.
For the reasons noted above, an institutional investor should not assume that simply having a custody agreement is enough to protect it in case the bank should fail. The investor must continue to monitor the custodian’s financial health and client protection protocols, and have a back-up plan in case worse comes to worse.
Despite these conclusions, I share the confidence of many banking law experts in the dedication and effectiveness of the FDIC in seeking to exclude custodial assets from a bank’s insolvency and to make the client whole to the extent legally permitted. Also, as discussed, these experts do not believe that Article 8 presents any real risk to custodial clients because the separation of client assets from proprietary assets is one of the most important and elemental functions of any major bank. This is comforting, but after the last four years it is safer (even if, one hopes, ultimately unnecessary) to be skeptical. In this context, as the saying goes, it is better to “trust but verify.”
As banking and finance become more mechanized and the securities trading system more complex, and after the Madoff, AIG, MF Global, and the LIBOR scandals, no institutional investor can safely rely on the proper conduct or undying good faith of any financial intermediary, including its custodian, especially when the firm is in extremis, and the investor’s board, clients, and fiduciaries will likely accept few excuses for any loss, no matter how unavoidable. The institutional investor must treat bank custody as another form of counterparty risk, and an unsecured one at that. It is incumbent upon the institution to do the best it can to protect its assets—wherever held—for their intended purpose.
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* General Counsel, University of Virginia Investment Management Company. The thoughts and opinions expressed here are entirely my own and do not necessarily reflect those of the University of Virginia Investment Management Company or the Rector and Visitors of the University of Virginia. This article does not convey legal advice and no one may rely on it as such.
I could not have written this article without the help of Marty Lybecker of Perkins Coie; Jim Frazer, Linda Hayman, Bill Sweet, and their colleagues at Skadden Arps; and Craig Unterberg of Haynes and Boone. I thank the editors of The Business Lawyer as well as William Kroener and Howard Darmstadter for their comments. In addition, I am grateful for the advice and encouragement of Larry Kochard, the CEO/CIO of UVIMCO. Finally, I thank my family, Susan, Jessica, and Rachel, for their constant support and patience during my work on this article.
2. In September 2011, Institutional Investor reported that over $94 trillion of assets were held in custody by the top fifteen worldwide custodians, of which approximately $67.8 trillion were custodied with five U.S.-based banks (in order of size): BNY Mellon, J.P. Morgan Chase, State Street, Northern Trust, and Brown Brothers. Julie Segal, Custodial Clients Push Regulation, INSTITUTIONAL INVESTOR, Sept. 2011, at 136, available athttp://www.institutionalinvestor.com/Article/2660428/Asset-Management-Archive/Custodial-Clients-Push-Regulation.html;see also Office of the Comptroller of the Currency, Interpretive Letter No. 1078, 2007 WL 1726580 (Apr. 19, 2007) [hereinafter OCC TLDA Letter], available athttp://www.occ.gov/static/interpretations-and-precedents/may07/int1078.pdf.
10. I have often observed misuse of the term “custody,” particularly by brokers, in describing asset services. For example, a broker recently assured me that a securities brokerage account is a bank “custody account.”
11. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (applying New York law).
12. 12 C.F.R. § 9.2(d), (e) (2012); see infra Part II.C.
It appears that the custody services handbook for bank examiners published by the Office of the Comptroller of the Currency fails to address bank negligence or bank misconduct. See CUSTODY SERVICES HANDBOOK, supra note 3; infra Part II.
19. With respect to terminology used in this article, the term “bank” includes national and state banks as well as trust companies. Trust companies are banks that limit their activities to trust services. See 2 ROBERT M. TAYLOR, III, BANKING LAW § 34.02, at 34-5 (2008) [hereinafter TAYLOR ON BANKS]. And, despite the various synonyms preferred by legislatures and courts to describe bank custody, I employ the term “custody” as it is used in the vernacular of business persons and banks. Last, unless I refer specifically to custodial accounts in which the custodian acts as investment manager or advisor, all discussions of custody accounts focus on “client-directed custody” in which the bank exercises no investment discretion and simply follows the directions of the client or its advisors.
21. SEC Rule 15c3-3 under the Securities Exchange Act of 1934, as amended, sets forth custody rules for securities accounts held at broker-dealers. 17 C.F.R. § 240.15c3-3 (2012).
22. These programs, called Trust Ledger Deposit Accounts, are discussed in, for example, the OCC TLDA Letter, supra note 2.
24. The FDIC has a set of “fiduciary account” custody rules that apply only if the bank has investment discretion. 12 C.F.R. §§ 9.1−9.20, 9.100−9.101 (2012). See Office of the Comptroller of the Currency, Fiduciary Activities of National Banks; Rules of Practice and Procedure, 61 Fed. Reg. 68543, 68546 (Dec. 30, 1996) (to be codified at 12 C.F.R. pts. 9, 19). The Custody Services Handbook summarizes rules relating to securities lending. CUSTODY SERVICES HANDBOOK, supra note 3, at 26– 36. Written before the 2008 crisis, the Handbook heralds securities lending as “one of the most important value-added products custodians offer to their customers.” Id. at 26. Some clients would disagree with that assessment today.
25. The collapse of Lehman Brothers in 2008 was widely reported. See, e.g., ANDREW ROSS SORKIN, TOO BIG TO FAIL: THE INSIDE STORY OF HOW WALL STREET AND WASHINGTON FOUGHT TO SAVE THE FINANCIAL SYSTEM—AND THEMSELVES (2009). Lehman’s role in the rehypothecation crisis is addressed in, for example, Rehypothecation by Lehman Leads to Fund Litigation, ORRICK CLIENT ALERT (Oct. 3, 2008), http://www.orrick.com/fileupload/1494.pdf.
27. Rehypothecation is the pledging of customer securities or other assets as collateral for the broker’s obligations. See discussion of rehypothecation in materials at supra notes 25–26.
28. 15 U.S.C. §§ 78aaa–78lll (2006 & Supp. IV 2010).
31. 12 U.S.C. §§ 1811−1835a (2006 & Supp. IV 2010).
32. Banks insured under the FDI Act may not file for bankruptcy. Bankruptcy Code § 109(b)(2), 11 U.S.C. § 109(b)(2) (2006). Instead, the FDIC will act as receiver of insolvent national banks and state banking authorities may appoint the FDIC to act as receiver of insolvent state-chartered banks, FDI Act § 11(c)(4), 12 U.S.C. § 1821(c)(4), and typically do so. Banks may be appointed as conservators rather than receivers, but this rarely occurs. FDI Act § 11(c)(2)(A)(i), (ii), 12 U.S.C. § 1821(c)(2)(A)(i), (ii); see Rich Hynes & Steven D. Walt, Why Banks Are Not Allowed in Bankruptcy, 67 WASH. & LEE L. REV. 985, 987 n.3 (2010).
34. Under relevant rules, the FDIC will close custody accounts and transfer the underlying assets pursuant to an order of the OCC and of the court with jurisdiction of the matter. See, e.g., 12 C.F.R. § 9.16 (2012) (for “fiduciary accounts,” i.e., accounts for which the bank has investment discretion); see also supra note 24.
35. FDIC Advisory Op. No. 03-01 ( Jan. 3, 2003) [hereinafter Advisory Op. No. 03-01], availableathttp://www.fdic.gov/regulations/laws/rules/4000-10190.html. But cf. FDIC Interpretive Letter No. 93-61, 1993 FDIC Interp. Ltr. LEXIS 91, at *4 (Aug. 25, 1993) (“Securities held in custody may take longer to return to or transfer for a customer, because the obligation is not the FDIC’s own and is part of an often complex estate requiring inventory and evaluation.”). Holders of “fiduciary accounts” (seesupra note 24) will also have a lien on the securities in the account in addition to their claim against the bank’s estate. 12 U.S.C. § 92a(e) (2006). It is unclear how this is juxtaposed with U.C.C. Article 8. See infra Part IV.
36. 12 U.S.C. § 1821( j) (2006); id. § 1821(d)(5); see Bank of Am. v. Colonial Bank, 604 F.3d 1239 (11th Cir. 2010). In In re Corestates Trust Fee Litigation, 39 F.3d 61, 66–67 (3d Cir. 1994), the court held that there is no private right of action to contest the FDIC’s exercise of its trust powers under section 92 of the FDI Act, but noted discordance among the federal circuits on this issue.
44. See 12 C.F.R. § 9.2(d), (e) (2012); see also discussion of “fiduciary accounts” at infra Part II.D.
45. See McLemore v. Regions Bank, 682 F.3d 414, 423 (6th Cir. 2012) (custody of assets does not by itself make a bank a fiduciary under ERISA); cf. Paloian v. FDIC, 2011 U.S. Dist. LEXIS 127376, at *11−13 (N.D. Ill. Nov. 2, 2011) (applying Illinois law and finding custodian has no duty to inves-tigate misuse of custody account by corporate officers). I am familiar with a recent custody agreement that obligates the bank to act as fiduciary with respect to the custodial duties it assumes under the agreement, but states that the bank’s fiduciary duty excludes any duty to exercise investment control, to make investment recommendations, or to oversee the conduct of the client’s authorized traders with respect to the assets held in custody.
46. Contractual risk does not appear to be addressed in the OCC’s Custody Services Handbook. See CUSTODY SERVICES HANDBOOK, supra note 3. The movement away from fiduciary responsibilities does not seem widely known. Recently I sought input on custody issues from the New York State Department of Financial Services, http://www.dfs.ny.gov (successor to the State Banking Department). The lawyer to whom I was directed expressed surprise and concern when I told her that to my knowledge it is not uncommon for banks to disclaim a fiduciary duty as custodian.
47. Am. Bar Ass’n, Annual Meeting—Bus. Law Section, Institutional Investors Comm. (Aug. 8, 2011).
49. AMY MORRIS HESS, GEORGE GLEASON BOGERT & GEORGE TAYLOR BOGERT, THE LAW OF TRUSTS AND TRUSTEES §§ 11, 15 (3d ed. 2007 & Supp. 2010); RESTATEMENT OF TRUSTS §§ 5, 8 (1935).
54. CUSTODY SERVICES HANDBOOK, supra note 3, at 3.
55. FDIC Advisory Op. No. 03-01, supra note 35; see also infra Part II.C. The question presented here related to a trust established under state law.
56. UNIF. TRANSFERS TO MINORS ACT § 1(7) (1986). See discussion of fiduciary accounts at infra Part II.C.
57. See, e.g., Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 106−07 (D.D.C. 2003).
58. E.g., N.Y. BANKING LAW § 96.3(a) (McKinney 2008 & Supp. 2012) (every bank is authorized “[t]o receive upon deposit for safe-keeping for hire upon terms and conditions to be prescribed by the bank or trust company, money, securities, papers of any kind and any other personal property”).
59. E.g., 760 ILL. COMP. STAT. ANN. § 75/2(b) (West 2007); 7 PA. CONS. STAT. § 408 (West 1995).
60. See, e.g., “special account” cases discussed at infra Part II.B.
61. This arrangement is described by the language of the New York Banking Law cited at supra note 58.
62. E.g., Henry Ridgely Horsey, The Duty of Care Component of the Delaware Business Judgment Rule, 19 DEL. J. CORP. L. 971, 974 (1994) (citation omitted) (traditionally, bank directors were required to exercise “the same degree of care and prudence that men prompted by self-interest generally exercise in their own affairs”).
63. According to reports, in 2011 the University of Texas Investment Management Company (“UTIMCO”) acquired $1 billion of gold bullion that was delivered to its custody bank. See, e.g., Robert Lenzner, University of Texas Endowment Holds $1 Billion Gold, 5% of Its Portfolio, FORBES (Apr. 17, 2011), http://www.forbes.com/sites/robertlenzner/2011/04/17/university-of-texas-endowment-holds-1-billion-gold-5-of-its-portfolio/; “Don’t Sell Gold Bars” Says Texas Fund Director, GOLD NEWS (Feb. 3, 2012), http://goldnews.bullionvault.com/gold_bars_020320121 (citing UTIMCO’s chief execu-tive officer); see also U.C.C. §§ 8-102(a)(9), 8-501(a) (2011) (custodial client’s rights under Article 8 of the U.C.C. apply equally to securities and other “financial assets” that the bank agrees to accept as such).
64. As noted in the Custody Services Handbook, banks can offer “document custody services” to support mortgage-backed and asset-backed securities and presumably other commercial products for which rights and obligations are evidenced by an original signed contract or other writing. CUSTODY SERVICES HANDBOOK, supra note 3, at 38–39.
67. See, e.g., 760 ILL. COMP. STAT. ANN. 75/3 (West 2007) (“fiduciary accounts” are to be segregated); MASS. GEN. LAWS ANN. ch. 167G, § 4 (West 2003) (a special deposit held by the trust department of a Massachusetts bank “shall not be mingled with” other assets); N.Y. BANKING LAW § 96.3(a) (McKinney 2008 & Supp. 2012) (banks have power “[t]o receive upon deposit for safe-keeping for hire . . . money, securities, papers of any kind and other personal property”). New York regulations also address common trust funds. N.Y. COMP. CODES R. & REGS. tit. 3, § 22.9 (2012). National bank law is discussed at infra Part II.C.
68. Cf. 3 MICHIE, supra note 52, § 184, at 484 (citations omitted) (a special deposit or deposit that is to be segregated from bank property will be entitled to priority of payment on a distribution of assets of an insolvent bank).
69. 12 U.S.C. § 91 (2006); 2 TAYLOR ON BANKS, supra note 19, § 36.05, at 36-17 to -18; cf. 3 MICHIE, supra note 52, § 189, at 508 (citations omitted); Hibernia Nat’l Bank v. FDIC, 733 F.2d 1403, 1407 (10th Cir. 1984) (addressing set-off rights); see also 12 U.S.C. § 1821(d)(17), (e)(1) (2006 & Supp. IV 2010).
70. See SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *75–77 (S.D.N.Y. Nov. 29, 2000), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009) (Revised Article 8 supplants the common law of bailment; “the property rights of securities [sic] entitlements [sic] holders over assets held by securities intermediaries are defined by Article 8 rather than by common law”). See also infra Part IV.
71. See Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 104 (D.D.C. 2003). See further discussion of “claims” in national bank insolvencies at infra Part II.C.
72. Seattle-First Nat’l Bank v. FDIC, 619 F. Supp. 1351, 1360 (W.D. Okla. 1985); see also, e.g., 12 C.F.R. § 360.8(c) (2012).
78. See Goldblatt v. FDIC, 105 F.3d 1325, 1329 (9th Cir. 1997) (a trust relationship is typically a prerequisite for special account status); see also FHLMC v. FDIC, 1985 U.S. Dist. LEXIS 19725, at *6–7 (E.D. Ky. May 17, 1985). New York law automatically applies a trust relationship if evidence establishes the existence of a special account. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (citing Genesee Wesleyan Seminary v. U.S. Fid. & Guar. Co., 159 N.E. 720 (1927) (Cardozo, J.)).
79. Merrill Lynch, 293 F. Supp. 2d at 106; cf. 12 U.S.C. § 92a (2006). Some older resources required a finding that the parties intended the return of specific assets to the customer, not their equivalents. This position appears to be long dismissed, Genesee Wesleyan, 159 N.E. at 722, although the argument was raised recently (and rejected by the court). Merrill Lynch, 293 F. Supp. 2d at 108–09.
80. Goldblatt, 105 F.3d at 1328–29; Peoples Westchester Sav. Bank v. FDIC, 961 F.2d 327, 330 (2d Cir. 1992); Paloian v. FDIC, 2011 U.S. Dist. LEXIS 127376, at *13 (N.D. Ill. Nov. 2, 2011) (fiduciary relationship not established simply by furnishing a custodial account); Merrill Lynch, 293 F. Supp. 2d at 103; cf. Sav. Bank of Rockland Cnty. v. FDIC, 668 F. Supp. 799, 805−06 (S.D.N.Y. 1987), vacated, 703 F. Supp. 1054 (S.D.N.Y. 1988).
81. E.g., Fletcher Vill. Condo. Ass’n v. FDIC, 864 F. Supp. 259, 265 (D. Mass. 1994).
83. 12 U.S.C. § 1823(e) (2006). This language, which was adopted as part of the Financial Insti-tutions Reform, Recovery, and Enforcement Act of 1989, codifies and expands the federal common law doctrine known as “D’Oench Duhme.” The doctrine, following a Supreme Court case of that name, permits disallowance of claims not recorded on the bank’s books if doing so would be inequit-able. D’Oench, Duhme & Co. v. FDIC, 315 U.S. 447, 458–60 (1942).
84. This topic is discussed more generally in Part VI.
86. E.g., O’Melveny & Myers v. FDIC, 512 U.S. 79, 89 (1994); see also Watters v. Wachovia Bank, 550 U.S. 1, 21 (2007).
87. TRUST EXAMINATION MANUAL, supra note 85, § 10.A.
88. Further support for this conclusion comes from the absence of any distinctions drawn between national and state banks in advisory opinions issued by the FDIC on the treatment of custodial assets in insolvency. See FDIC Advisory Op. No. 03-01, supra note 35; FDIC Advisory Op. No. 88-14, supra note 53; FDIC Advisory Op. No. 87-7, supra note 53.
89. FDIC v. Prince George Corp., 58 F.3d 1041, 1045 (4th Cir. 1995).
90. See, e.g., Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 104 (D.D.C. 2003).
91. 12 U.S.C. § 24, Seventh (2006); see also 2 TAYLOR ON BANKS, supra note 19, § 26.02, at 26-5.
93. First Nat’l Bank of Logan v. Walker Bank & Trust Co., 385 U.S. 252, 261 (1966); see also, e.g., 2 TAYLOR ON BANKS, supra note 19, § 34.02, at 34-4 (for trust accounts).
94. The OCC has stated that “[n]ational banks’ custody activities developed from providing safe-keeping and settlement services to customers for a fee, and historically are viewed as permissible incidental activities under 12 U.S.C. § 24 (Seventh), and often are in conjunction with the delivery of fiduciary services.” OCC TLDA Letter, supra note 2, at 3 (emphasis added).
96. Id. § 92a(a); cf. 12 U.S.C. § 1813(p), 1817(l) (2006) (discussing the general treatment of fiduciary accounts under section 92a in “trust funds” at FDIC-insured depository institutions); 12 C.F.R. §§ 150.10−150.60 (2012) (containing the OCC’s rules for trust accounts at federal saving associations).
Banks have specific duties relating to trust funds, including:
The bank must be authorized by the OCC to provide trust services (see generally 2 TAYLOR ON BANKS, supra note 19, §§ 34.03–34.05);
The bank must segregate trust assets from the bank’s general assets and keep a separate set of books and records of transactions (12 U.S.C. § 92a(c));
The bank must implement written rules and procedures relating to custody accounts, including those preventing self-dealing, conflicts of interest, and use of confidential information (12 C.F.R. § 9.5); and
The bank owes undivided loyalty to custody clients and must avoid self-dealing and conflicts of interest (12 C.F.R. § 9.12).
Importantly, the bank’s board of directors must conduct an audit of its trust department at least annually to determine whether the trust department is properly administering its responsibilities (12 C.F.R. § 9.9). The audit may be continuous rather than annual (12 C.F.R. § 9.9(b)), which would certainly be more comforting to clients. I do not know how common this is.
97. E.g., FDIC Advisory Op. No. 03-01, supra note 35 (question pertains to a “regulated financial institution” without further description).
100. FDIC Advisory Op. No. 88-14, supra note 53; cf. O’Melveny & Myers v. FDIC, 512 U.S. 79, 86 (1994) (citation omitted) (the FDIC “steps into the shoes” of the insolvent financial institution).
103. In the case of accounts for which the custodial bank has investment discretion, such as ERISA plan accounts, section 92a(e) of the FDI Act grants holders of “funds held in trust for investment . . . a lien on the bonds or other securities so set apart in addition to their claim against the estate of the bank.” 12 U.S.C. § 92a(e) (2006). I have found no sources analyzing the meaning of this language. Presumably, it grants trust clients a lien on securities or security entitlements that left the account prior to insolvency. This is not different from the rule at common law, and to the extent banks adhere to it or the FDIC enforces it, this lien possibly offers better protection to ERISA clients and others who meet the trust account requirements of section 92a than other custodial clients. See supra Parts II.A. & B. But, as discussed in Part IV, this lien is inconsistent with Article 8 of the U.C.C. to the extent it covers securities that are no longer credited to the account.
110. Recently, a lawyer representing a large U.S. custody bank told me that, before I had men-tioned it, none of its lawyers was aware of FDIC Advisory Op. No. 03-01, supra note 35, and that their view was that the opinion is wrong because it adds a fiduciary duty that does not exist under current law.
111. See, e.g., TRUST EXAMINATION MANUAL, supra note 85, § 10.A (although state laws “do not always uniformly identify what functions constitute ‘fiduciary’ activities requiring trust powers” and “a bank may claim it is not acting in a ‘trust’ capacity,” state law will determine whether an activity constitutes fiduciary or trust powers).
113. TRUST EXAMINATION MANUAL, supra note 85, § 10.D.
114. E.g., FDIC v. Phila. Gear Corp., 476 U.S. 426, 439 (1986) (citation omitted). The principle of Philadelphia Gear—that Congress may be deemed to accept an established regulatory rule or practice if it fails to address it in legislation relevant to the general topic—may explain why the “living will” provisions of Dodd-Frank do not require covered banks to address their treatment of custodied assets as part of their resolution plans. See Dodd-Frank Act §§ 165, 166, 12 U.S.C. §§ 5365, 5366 (Supp. IV 2010). For more on the Dodd-Frank living will provisions, see generally, e.g., Eugene A. Ludwig, As-sessment of Dodd-Frank Financial Regulatory Reform: Strengths, Challenges, and Opportunities for a Stronger Regulatory System, 29 YALE J. ON REG. 181 (2012); Margaret E. Tahyar, Living Wills: Key Lessons fromthe First Wave, HARV. L. SCH. FORUM ON CORP. GOVERNANCE & FIN. REG. ( July 24, 2012), http://blogs.law.harvard.edu/corpgov/2012/07/24/living-wills-key-lessons-from-the-first-wave/.
116. 12 U.S.C. § 1821(a)(1)(E) (2006 & Supp. IV 2010). The law provides for inflation adjust-ment to this figure. 12 U.S.C. § 1821(a)(1)(F) (2006).
117. Hedge Fund Investors Want Safe Havens for Managers’ Cash, supra note 1.
118. At last report the program is available through December 31, 2012. See Temporary LiquidityGuarantee Program, FED. DEPOSIT INS. CORP. (Oct. 2, 2012), http://www.fdic.gov/regulations/resources/TLGP/index.html. However, banks can opt not to offer the insurance or to charge a fee for doing so, thus resulting in negative interest costs.
121. FDIC Advisory Op. No. 88-14, supra note 53 (treasury bills do not create a deposit relation-ship; rather, the relationship is “in the nature of a bailment”); see also Insured or Not Insured?, supra note 115.
122. See, e.g., Peoples Westchester Sav. Bank v. FDIC, 961 F.2d 327, 331 (2d Cir. 1992) (an interest component is “very strong evidence” that an account is a general asset absent other evidence of parties’ intent (citation omitted)). But cf. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 108 (D.D.C. 2003) (declaring that Interest on Lawyer Account (“IOLA”) obligations should be considered custodied assets despite the interest component because New York law required that these accounts bear interest); Peoples Westchester, 961 F.2d at 332–33 (Altimari, J., dissenting).
123. See Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (applying New York law).
124. Merrill Lynch, 293 F. Supp. 2d at 108 (citations omitted); cf. Peoples Westchester, 961 F.2d at 331 (“We do not say that an IOLA can never be a special deposit. We simply conclude that in order for an IOLA to qualify as a special deposit, the parties must explicitly provide that it be one.”).
125. Department of the Treasury, Office of the Comptroller of the Currency, Short-Term Investment Funds, 77 Fed. Reg. 21057, 21058 (proposed Apr. 9, 2012) (to be codified at 12 C.F.R. pt. 9).
127. E.g., MORGAN STANLEY PRIVATE WEALTH MANAGEMENT, TERMS & CONDITIONS 3 (2011) (on file with The Business Lawyer).
128. SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *75–77 (S.D.N.Y. Nov. 29, 2000); aff’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009); Rogers, supra note 15, at 1506.
129. I thank Linda Hayman of Skadden Arps for introducing me to these terms and the underlying principles.
133. See generally Rogers, supra note 15, at 1499–1502. The Official Prefatory Note to Article 8 analogizes the recordkeeping function to real estate recording:
Article 8 deals with how interests in securities are evidenced and how they are transferred. By way of a rough analogy, one might think of Article 8 as playing the role for the securities markets that real estate recording acts play for the real estate markets. Real estate recording acts do not regulate the conduct of parties to real estate transactions; Article 8 does not regulate the conduct of parties to securities transactions.
U.C.C. Article 8 Official Prefatory Note § III.B; see also Rogers, supra note 15, at 1499–1500 (“The expectation is, and should be, that the keepers of the real estate recording system will promptly, efficiently, and carefully record whatever documents are presented to them. The same approach is appropriate for the legal rules governing the mechanics of the system of securities holding through intermediaries. The principal objectives of such a body of law should be to assure that the record-keepers can operate the system rapidly, efficiently, and at low cost, and that investors can be assured that their record-keepers will, promptly and without question or inquiry, implement changes in the records at the direction of the customer.”).
Many, if not most, aspects of the relationship between brokers and customers are governed by the common law of contract and agency, supplemented or supplanted by federal and state regulatory law. Revised Article 8 does not take the place of this body of private and regulatory law. If there are gaps in the regulatory law, they should be dealt with as such; Article 8 is not the place to address them.
U.C.C. Article 8 Official Prefatory Note § III.B. However, as noted at infra note 136, Article 8 supplants the common law of bailment. This may create a challenge when a bank plays the dual role of securities intermediary and trustee of custodied assets. The Official Prefatory Note states that:
Bank, qua securities custodian, might be holding securities for a large number of customers, including Bank’s own trust department. Insofar as Bank may be regarded as acting in different ca-pacities, Part 5 of Article 8 may be relevant to the relationship between the two sides of Bank’s business. However, the relationship between Bank as trustee and the beneficiaries of the trust would remain governed by trust law, not Article 8.
U.C.C. Article 8 Official Prefatory Note § III.C.5. Query how this is possible to the extent that Article 8 does not allow tracing and instead requires proportionate recovery of shortfalls. See infra notes 158–159 and accompanying text.
135. U.C.C. § 8-503 cmt. 1 (2011). In my view, the fact that a bank typically plays more than strictly a role of fiduciary or trustee highlights the limits of the real estate recording analogy discussed at supra notes 133–34. See infra Part VI.
136. SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *79–80 (S.D.N.Y. Nov. 29, 2000) (citing U.C.C. § 8-503 cmt. 2), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009); Rogers, supra note 15, at 1506 (“Under Revised Article 8, the relationship between a securities custodian and its customer is no longer treated as an aspect of common law bailment. Rather, the relationship is defined by the statement of the statutory duties of an intermediary in Part 5 [of Revised Article 8].”). Note, however, that when a bank holds securities that are titled in the name of the client, the securities are held as a bailment, not a security entitlement. U.C.C. § 8-501 cmt. 8 (2011).
137. See U.C.C. § 8-102(a)(14) (2011) (definition of “securities intermediary”), id., § 8-102(a)(5) (definition of “clearing corporation”), id., § 8-102(a)(3) (definition of “broker”).
140. See id. § 8-102(a)(4) (definition of “certificated security”), id., § 8-102(a)(18) (definition of “uncertificated security”).
141. Note that the terms “direct” and “indirect” as used in the custody context (see supra note 65 and accompanying text) may create ambiguity when referring to the custody of financial assets. Under U.C.C. Article 8, a client holds a security “directly” only if it is registered as the holder on the issuer’s books. So if a security intermediary holds a security certificate for the client, the client holds directly if the certificate is registered in its name, and indirectly (that is, the client only has a security entitlement) if the certificate is registered in the intermediary’s name. A complication to the foregoing is when a stock certificate is registered in the client’s name but the client has endorsed the certificate or given the intermediary signed stock powers. In that case, the customer is deemed to hold the security indirectly. See U.C.C. § 8-501(d) (2011).
143. Note that the term “control” has separate definitions for control of securities (certificated and uncertificated) as distinguished from control of a security entitlement. Compare id. § 8-106(a)−(c) with id. § 8-106(d).
144. A “purchaser” acquires an asset “by sale, discount, negotiation, mortgage, pledge, lien, issue or re-issue, gift or any other voluntary transaction creating an interest in property.” U.C.C. §§ 1-201(32), 1-201(33) (2011); see also U.C.C. § 8-116 (2011).
147. U.C.C. Article 8 Official Prefatory Note § II.D (2011).
148. U.C.C. § 8-503(d), (e) (2011) (recovery against a third party is prohibited if it gave value, obtained control, and did not act in collusion with the bank). U.C.C. § 8-503 cmt. 2 states:
A security entitlement is not a claim to a specific identifiable thing; it is a package of rights and interests that a person has against the person’s securities intermediary and the property held by the intermediary. The idea that discrete objects might be traced through the hands of different persons has no place in the Revised Article 8 rules for the indirect holding system. The funda-mental principles of the indirect holding system rules are that an entitlement holder’s own intermediary has the obligation to see to it that the entitlement holder receives all of the economic and corporate rights that comprise the financial asset, and that the entitlement holder can look only to that intermediary for performance of the obligations. The entitlement holder cannot as-sert rights directly against other persons, such as other intermediaries through whom the intermediary holds the positions, or third parties to whom the intermediary may have wrongfully transferred interests, except in extremely unusual circumstances where the third party was itself a participant in the wrongdoing.
154. Since banks clearly demarcate client assets, I would presume that if this were to happen it would occur in more than one step, say, the asset (or, more accurately, the record of ownership of the asset) moves from the custody account to the bank’s proprietary account, and from there to a creditor account, in circumstances where the matter cannot be corrected before the bank’s insolvency.
155. U.C.C. § 1-203 (2011) (“Every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement.”); see also U.C.C. § 8-511 cmt. 1.1 (2011).
156. Note that in New York mere knowledge may satisfy the collusion requirement. See Howard Darmstadter, Three Article 8 Cases, 57 BUS. LAW. 1741, 1746–50 (2002) (citing New York legislative history).
160. Id. (“Although this section [section 8-503] describes the property interest of entitlement holders in the assets held by the intermediary, it does not necessarily determine how property held by a failed intermediary will be distributed in insolvency proceedings. If the intermediary fails and its affairs are being administered in an insolvency proceeding, the applicable insolvency law governs how the various parties having claims against the firm are treated. For example, the distributional rules for stockbroker liquidation proceedings under the Bankruptcy Code and the Securities Investor Protection Act (‘SIPA’) provide that all customer property is distributed pro rata among all customers in proportion to the dollar value of their total positions, rather than dividing the property on an issue by issue basis. For intermediaries that are not subject to the Bankruptcy Code and SIPA, other insolvency law would determine what distributional rule is applied.”).
164. U.C.C. § 8-503 cmts. 1, 2 (2011); see SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *70 (S.D.N.Y. Nov. 29, 2000), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009).
169. For example, as discussed further in Part VI, an institution with a concentrated exposure in a particular security—say, a foundation that is endowed with a large position in its founder’s company—may wish to retain a physical certificate in such number of shares that it intends to retain for long-term investment.
174. For example, New York law relating to common trust funds requires that the custodian’s subcustody contracts with foreign banks require client securities be kept free of creditor claims and be identified as being owned by the U.S. custodian as fiduciary. N.Y. COMP. CODES R. & REGS. tit. 3, § 22.9 (2012). The law also requires proper recordkeeping and audit rights. Id.
177. The OCC’s Custody Services Handbook recommends that a bank use a “standardized” custody agreement “when possible.” CUSTODY SERVICES HANDBOOK, supra note 3, at 8.
179. For example, last year the Chicago Board Options Exchange began offering CEBOs—Credit Event Binary Options—that trade based on the likelihood of a company experiencing a “credit event.” See Credit Event Binary Options (CEBOs) from CBOE, CHI. BD. OPTIONS EXCH., http://www.cboe.com/micro/credit/introduction.aspx (last visited Oct. 21, 2012).
The phone rings. It’s your client, a secured lender, in a panic. His borrower just defaulted, and he can’t find the remedies section in the security agreement. “How am I going to foreclose on collateral,” he asks, “without any contractual remedies? What good does a naked security interest do me?” The client sends you the security agreement and you find that while there is a clear security interest and default, the agreement is silent on applicable remedies and timing of enforcement. How do you advise your client?
Thankfully, your client has hope. While it may be unusual to have a security agreement without express remedies, in this case, your client merely needs to think outside the box–or at least outside of the four corners of the agreement. Article 9, Part 6 of the Uniform Commercial Code (UCC), sets forth statutory remedies available to all secured lenders, whether or not they are expressly provided by agreement. These rights include the right to collect on collateral, the right to repossess collateral, the right to sell or dispose of collateral, and the right to retain the collateral in full or partial satisfaction of the debt with the borrower’s consent. See UCC §§ 9-607, 9-609, 9-610, 9-620. This article provides a roadmap of these statutory rights and remedies, as well as the obligations and standards of care to which secured parties must adhere and the effects of secured party noncompliance with such standards.
Article 9 Remedies–Overview
Article 9 remedies, including the remedies in Part 6, are available to any secured party after its borrower, or in Article 9 terms, “debtor,” defaults under a security agreement (but the exercise of such remedies may be limited and subject to court approval if the debtor is in bankruptcy). What constitutes a “default” is not defined in Article 9; rather, such determination is left to the agreement of the parties pursuant to the applicable security agreement or loan agreement. Contractual defaults commonly include failure to pay or comply with covenants, misrepresentations, judgments against the debtor, bankruptcy, and defaults under other agreements.
While Article 9 does not contain any explicit requirement that a default be material to afford a secured party the right to enforce against collateral, it does generally obligate a secured party to act in good faith when exercising such rights. For example, if a secured party pursues Article 9 remedies after a debtor delivers satisfactory financial statements one day late, such action could be an overreaction to a relatively minor breach. The secured party should thus assess materiality in terms of whether the applicable default puts the credit at risk. See, for example, Banc of Am. Leasing & Capital, LLC v. Walker Aircraft, LLC, 2009 U.S. Dist. LEXIS 94657 (D. Minn. 2009).
Collection and Enforcement
The Right to Collect: Provisions and Benefits
UCC § 9-607 provides secured parties with the remedy of collection. This remedy applies to certain types of liquid assets, including accounts receivable, general intangibles, chattel paper, notes, deposit accounts, and other intangible assets that oblige an underlying obligor to make payment or render performance to the debtor. See UCC § 9-607(a). Section 9-607 allows the secured party to collect directly from the underlying obligor, but the secured party must account to the debtor for any surplus in the collection of the collateral. See UCC § 9-608. The right to collect is an attractive remedy for secured parties because it is often the fastest remedy available, allows the secured party to act without disrupting the debtor’s business, and provides access to liquid assets.
The secured party may exercise the right to collect from underlying obligors at any time if its security agreement so provides. If the agreement does not address that right, the secured party may still collect directly from underlying obligors (or other persons obligated to make payment on that collateral) upon the debtor’s default. See UCC § 9-607(a). For example, after default the secured party may collect on pledged accounts receivable or apply funds from a pledged deposit account in which a security interest has been appropriately perfected to reduce the outstanding secured obligations. Article 9 even allows a secured party to foreclose a pledged mortgage (if applicable state law permits it) or enforce payments under a pledged promissory note (provided, of course, that the underlying obligations are in default). UCC §§ 9-607(a); 9-607, Comment 6 and Comment 8.
Specific Requirements and Duties: Commercial Reasonableness
A secured party must act in a commercially reasonable manner when exercising its direct collection rights. UCC § 9-607(c). This requirement includes notifying underlying obligors of impending collections. UCC § 9-607(a)(1). As a practical matter, in order to provide notice, the secured party must have access to the debtor’s current records and accounting with respect to underlying receivables. The secured party may obtain access via judicial action if the debtor is uncooperative. The commercial reasonableness requirement is not waivable by agreement of the parties. UCC § 9-602(3).
Defenses
An underlying obligor on an account, chattel paper or payment intangible generally has an obligation to pay the secured party if the debtor or secured party properly notifies it that payment is required. UCC § 9-406(a). Such notice is sometimes referred to as a cutoff notice as it is viewed as cutting off payments to the debtor. If an underlying obligor has a valid defense to payment (such as prior exercise by the debtor of setoff rights against such underlying obligor), though, it need not pay so long as the defense arose before it received the cutoff notice from the debtor or secured party. UCC § 9-404(a)(2). Earlier collection notification by the secured party, then, is beneficial because it also cuts off defenses for the underlying obligor.
Repossession
The Remedy of Repossession
The remedy of repossession is quite powerful, as the threat of repossession can incentivize a debtor to comply with the security agreement and repay its obligations. Repossession also assures the secured party that, if something goes awry, it can recoup some value on its investment by taking the collateral. Note, however, that repossession is only a temporary solution if used in isolation. The secured party cannot hold collateral indefinitely, and has duties with respect to the collateral it holds, including maintenance, reasonable disposition, and the duty to take reasonable care of collateral in its possession. SeeUCC §§ 9-601, 9-207. The debtor also has the right to redeem collateral held by the secured party in exchange for fulfillment of the secured obligations (in other words, repayment of the loans). UCC § 9-623.
Basic Rules of Repossession
After default, the secured party may take possession of collateral either with judicial process, or without judicial process if there is no breach of peace. UCC § 9-609(b). If repossession without judicial process does result in a breach of peace, the secured party may be liable for conversion or trespass. The UCC does not define a breach of peace, and a significant body of case law has developed in response. See UCC § 9-609, Comment 3. In assessing breaches of peace, courts balance the secured party’s right to repossess collateral against possible danger to the public.
Lenders should be aware of several other key repossession issues. First, if the collateral is an object too large to move, such as a piece of equipment, the secured party may render the collateral unusable and dispose of it on the debtor’s premises after default. UCC § 9-609(a)(2). Additionally, the secured party is responsible for its agent’s actions and will face liability for any unreasonable repossession conducted on its behalf by an independent contractor. UCC § 9-609, Comment 3. Lenders should also be aware that using a law enforcement officer to accomplish repossession may result in a breach of peace if the officer’s services were not obtained via judicial process. Finally, the secured party and the debtor cannot waive the breach of peace requirement or contractually define a breach of peace because the requirement protects the general public and others who are not in contractual privity. UCC §§ 9-602, 9-603(b).
Disposition
Disposition Generally
Disposition is the secured party’s primary Article 9 remedy. Disposition includes any sale, lease, license, or other disposition of collateral. UCC § 9-610(a).
Secured Party’s Duties before Disposing of Collateral
The secured party may dispose of any or all collateral either in its existing condition or following commercially reasonable processing, subject to certain limitations. UCC § 9-610(a). Reasonable processing typically means any minimal preparation that could impact the sale price. For example, if a vehicle or piece of equipment would fetch a higher price if cleaned prior to sale, it could be unreasonable not to clean it. See, for example, Liberty Nat’l Bank & Trust Co. of Okla. City v. Acme Tool Div. of Rucker Co., 540 F2d 1375 (10th Cir., 1976). If collateral is incomplete, though, it is sometimes unreasonable to expect the secured party to complete it prior to sale. See UCC § 9-610, Comment 4. For instance, the secured party may lack the requisite knowledge to complete an unfinished computer program, and so the secured party could sell the collateral in its then-present state. As with other Article 9 rights, such sale will be subject to a commercial reasonableness test. UCC § 9-610(b). Price is not necessarily a factor in this test, but the process, time, and place of the sale will be considered.
Public versus Private Sale
The secured party may dispose of property through a public or a private sale. UCC § 9-610(c). In a public sale or auction, a public notice is given and any purchaser may bid, subject in some cases to eligibility criteria established by the secured party. In a private sale, the secured party seeks out interested parties and agrees on sale terms without an auction. The decision whether to pursue a public or private sale must be made in a commercially reasonable manner. UCC § 9-610, Comment 2.
With the exception of certain types of collateral such as publicly traded securities, the secured party cannot purchase its own collateral in a private sale. UCC § 9-610(c)(2). The policy reason for this requirement is that collateral should be tested by the market to determine the best price. See UCC § 9-610, Comment 7. Therefore, the secured party may buy in a private sale collateral of a kind that is customarily sold on a recognized market or is the subject of widely distributed standard price quotations, because there is already an established market for such collateral. UCC § 9-610(c)(2). In a public sale, the secured party may buy any collateral on which it bids. UCC § 9-610(c)(1).
Notification before Disposition of Collateral (§ 9-611)
Prior to disposition, the secured party must send notification of its intent to dispose of collateral to the debtor (unless, after default, the debtor waives the right to notification), secondary obligors (such as guarantors), other secured parties or lienholders who have requested in advance to be notified, and any secured parties or lienholders of record. UCC § 9-611(c). The secured party must run UCC searches before disposition to identify such parties. The UCC provides a safe harbor here, presuming notification compliance if the secured party searches no later than 20 days or earlier than 30 days prior to the notification date and notifies the secured parties or lienholders of record at that time. UCC § 9-611(e)(1).
The secured party must also provide the notice of disposition within a reasonable time. In commercial transactions, a 10-day notice period is considered per se reasonable. UCC § 9-612(b). Any shorter time frame will be subject to a reasonableness test. In consumer transactions, there is no safe harbor, and notice is always subject to a reasonableness test. UCC § 9-612(a). Parties often add safe harbor provisions to their security agreements, agreeing that a specified number of days’ notice will be commercially reasonable. UCC § 9-603(a) supports the enforceability of such provisions, so long as the stated notice period is not manifestly unreasonable.
Application of Proceeds to Disposition; Liability for Deficiency and Right to Surplus (§ 9-615)
Section 9-615 sets forth the priority in which payments should be made from sale proceeds. The foreclosing secured party’s expenses take first priority, followed by its secured obligations, and then the secured obligations of any junior secured parties who have provided a demand. If excess surplus exists after all expenses are paid and obligations are satisfied, the secured party must remit the remaining proceeds to the debtor. If the sale results in a net deficiency, the debtor is liable for that deficiency. If the foreclosing secured party is not the senior secured party, the foreclosure sale does not extinguish the senior secured party’s lien and the purchaser at the disposition sale takes subject to that senior lien.
Acceptance of Collateral
Under UCC § 9-620, a secured party may accept collateral in total satisfaction of the secured debt (or partial satisfaction for non-consumer agreements) if it complies with two requirements. The first requirement is acquiescence. In the case of partial satisfaction, the debtor must explicitly consent to the amount of partial satisfaction in an authenticated record created after default. UCC § 9-620(c)(1). In the case of full satisfaction, the debtor may consent either in an authenticated record or by deemed consent if it fails to respond to the secured party’s notice of proposal to accept collateral within 20 days. UCC § 9-620(c)(2).
The second requirement to effect acceptance of collateral is to confirm that no parties entitled to notice thereof object to the acceptance of collateral. UCC § 9-620(a)(2). The parties entitled to notice are the debtor (who may waive the right to notice after default), a secondary obligor entitled to notice under UCC § 9-621(b), and other secured parties or lienholders that have filed lien records within 10 days prior to the debtor’s consent. Each such party has 20 days to object before the partial satisfaction agreement becomes official. UCC § 9-620(d)(1). If the secured party searches lien records and simultaneously sends notice to the debtor so the 10-day filing period and the 20-day objection period run concurrently, the secured party can search again within 10 days of debtor consent to ensure that no new secured parties have filed. UCC § 9-621(a)(2). If new filings occur, those secured parties must be notified and given their 20 days to object to the partial satisfaction agreement.
If any person, whether entitled to notice of the proposal to accept collateral or otherwise, makes a timely objection to the secured party’s proposal, such objection prevents the acceptance of collateral from taking effect. See UCC § 9-620, Comment 8. An objection from any person entitled to notice is timely if received by the secured party within 20 days of the date such person received the requisite notice, and an objection from any other person is timely if received before the debtor agrees to (or is deemed to agree to) the acceptance.
Secured Party Noncompliance
While Article 9 is generous in supplying statutory remedies to secured parties, these gifts come with a price–the requirement that the secured party comply with the rules and standards set forth in Article 9. Failure to comply can have serious consequences for a secured party.
If the secured party fails to comply with Article 9’s requirements, the debtor, secondary obligors, or other lienholders can attempt to enjoin the secured party from proceeding. UCC § 9-625(a). Additionally, if the secured party breaches Part 6 of Article 9 during a disposition, perhaps by acting in a commercially unreasonable manner or failing to give required notice, it may be liable to the debtor, secondary obligors, or other secured parties or lienholders for losses resulting from such noncompliance, and may be required to pay statutory damages. UCC §§ 9-625(b), 9-625(e). This liability exists alongside non-UCC remedies, such as trespass for breach of peace or conversion in the case of an unreasonable disposition.
Noncompliance can also impact a secured party’s ability to charge debtors for any deficiency in the amount of the secured party’s recovery and a secured party’s obligation to pay over any surplus recovery to the debtor. In a commercial transaction where the amount of a deficiency or surplus is at issue, a secured party typically does not have to prove compliance with the Part 6 remedies of the UCC. UCC § 9-626(a)(1). If, however, a debtor questions the steps taken by the secured party, the secured party carries the burden of demonstrating compliance. UCC § 9-626(a)(2). For this reason, the secured party should keep detailed records when exercising remedies to provide evidence of commercial reasonableness and compliance with other statutory remedies if necessary.
In the event of a dispute over a secured party’s compliance with Article 9 in a non-consumer transaction, UCC § 9-626(a) sets forth specific rules for determining the amount of any deficiency judgment the secured party can collect from the debtor. Under these rules, a non-complying secured party may be prevented from recovering any deficiency at all or may have its deficiency amount reduced. For example, unless the secured party can prove the actual amount it would have recovered in a compliant sale, the secured party will not be entitled to a deficiency payment because the presumption under Article 9 is that the proceeds which would have been recovered in a compliant sale would have equaled the amount of the outstanding secured obligations. UCC § 9-626(a). Courts have more discretion to determine deficiency payments or surpluses in consumer transactions. UCC § 9-626(b). Courts can also assess additional statutory damages in consumer transactions under UCC § 9-625(c).
Conclusion
Article 9 of the UCC provides a valuable set of tools to a secured party wishing to enforce its rights following a debtor default. These tools are helpful to secured parties even when security agreements are silent on remedies. Such statutory remedies provide comfort to a secured party that even if the contract is silent, the secured party nevertheless has certain rights available to it as a matter of law. All it has to do is think outside the box.
Asset forfeiture has ancient roots. At its inception it was used by governments to fight piracy. More recently, it has emerged as a powerful tactical weapon in the fight against organized crime and drug trafficking organizations. It is also an indispensible tool in federal white collar crime prosecutions. According to most recent statistics, half of all federal forfeiture cases involve white collar crime. This development is crucial to understanding the importance of asset forfeiture in contemporary criminal prosecutions. White collar crime, in its modern incarnation, affects vast numbers of victims who suffer large monetary losses. Without the recovery of funds made possible through the use of asset forfeiture, victims would be left to their own devices in recovering their losses. During the past decade, the Department of Justice used asset forfeiture to recover nearly $3 billion in criminal fraud proceeds that were returned to victims through the Victim Asset Recovery Program (VARP). So, what is asset forfeiture? How does it work? And how did it become an integral component in the recovery of assets for victims?
What is Asset Forfeiture?
Asset forfeiture is commonly understood to be the divestiture without compensation of property used in a manner contrary to the laws of the sovereign. Simply stated, it is the taking of property derived from a crime, involved in a crime, or which makes a crime easier to commit or harder to detect. For example, let’s consider an individual–Mr. Slick–who uses his business to run a Ponzi scheme and then takes the fraud proceeds to support a lavish lifestyle through the purchase of expensive items like houses, cars, and boats. The government may pursue a forfeiture of the business because it was involved in a crime and made the crime easier to commit or harder to detect. Because the houses, cars, and boats were derived from the crime, a forfeiture of these assets may also be pursued.
A Brief History of Asset Forfeiture
Asset forfeiture’s early roots were grounded in admiralty law as a way for governments to prevent the owner of ships engaged in piracy and the smuggling of goods to continue their criminal activity. If a ship’s crew was arrested, the owner simply hired a new crew and continued the illegal activity. However, if the government forfeited the ship, this prevented the criminal activity from continuing.
Fast forward to the 1970s and the 1980s, when the criminal landscape changed, and asset forfeiture was deployed against criminal organizations, including drug trafficking organizations. Law enforcement began to target not only the individuals who controlled these organizations, but also the money that was their lifeblood.
Recognizing the effectiveness of forfeiture in the fight against drug trafficking and organized crime, Congress expanded the use of forfeiture for other criminal offenses, especially those involving fraud and other white collar crime, once again changing the landscape of forfeiture. This ancient tool is now an indispensible means of seizing and preserving assets for victims of white collar crime.
Why Use Asset Forfeiture?
There are many important and compelling reasons to use asset forfeiture to fight crime. In the example above, the fraudster, Mr. Slick, is committing the fraud for one primary reason: good old-fashioned greed. Simply prosecuting and convicting this individual for fraud does not address his primary motivation for committing the crime in the first place. By going after the money he generated from the fraud, forfeiture takes away the principal incentive for the crime and punishes the criminal for his illicit conduct where it hurts most.
Asset forfeiture is also an effective way to remove the tools of the trade from the criminal. Just like the pirate who would continue to seek his prey on the open seas as long as he had a ship, the modern fraudster can use businesses and other assets to harm the public, unless they are taken away. The government’s forfeiture of the fraudster’s business takes away the essential tool which allows him to conduct his Ponzi scheme.
Finally, and perhaps most importantly, asset forfeiture can be used to protect and benefit those most harmed by criminal activity. It has been used to seize crack houses that pose a threat to public health and safety, which are then turned over to non-profit organizations and used to redevelop neighborhoods blighted by drugs and crime. And as discussed above, forfeited property has been used to recover and return billions of dollars to individuals victimized by white collar fraud. In sum,asset forfeiture deters crime by removing the tools of crime from the criminals and their organizations, deprives wrongdoers of the proceeds of crime, recovers property that may be used to compensate, and otherwise benefit, victims.
What Can Be Forfeited?
Depending on the crime, the government can forfeit a wide variety of property and interests in property, including:
Proceeds: the proceeds of the crime (which includes anything of value obtained as a result of the crime and property traceable to those assets);
Facilitating property: the property used to make the crime easier to commit or harder to detect; and
Property involved in: the property involved in a money laundering offense (which includes the money being laundered and the money and other property that is commingled with it).
Under federal forfeiture law, property is considered anything of value, both tangible and intangible, including rights, privileges, interests, claims, and securities. The key to being able to forfeit property is that it has to be connected to a crime, and federal law must authorize forfeiture for that crime. In other words, every forfeiture must be authorized by a specific statute. In the United States, there is no general forfeiture statute that covers all property and all crimes. However, forfeiture is available for over 200 different federal, state, and local crimes. Perhaps the best known forfeiture statutes allow the forfeiture of drug proceeds and any type of property used to commit the drug offense. In money laundering cases, forfeiture statutes allow the forfeiture of all property involved in the money laundering offense. In mail and wire fraud cases, forfeiture statutes allow the forfeiture of the proceeds of the crime. In Racketeer Influenced and Corrupt Organizations (RICO) cases, forfeiture statutes allow the forfeiture of any property acquired or maintained through the racketeering activity.
Types of Forfeiture
Administrative Forfeiture
The vast majority of federal forfeiture cases go uncontested. Uncontested forfeitures are commonly known as “administrative forfeitures” because they are processed by the law enforcement agency that seized the assets. Since no one has stepped forward to challenge the forfeiture, courts are not involved in the process. Administrative forfeitures can only be pursued if federal law authorizes the seizing law enforcement agency to proceed in this manner, and if the property being forfeited (excluding cash and other monetary instruments) is less than $500,000. Houses and other real property may not be forfeited administratively. Federal law imposes strict deadlines and stringent notification requirements upon law enforcement agencies that engage in administrative forfeitures.
For example, under the facts of our fraud scenario, the FBI–an agency with administrative forfeiture authority–may seize Mr. Slick’s personal assets, which are valued at less than $500,000. FBI obtains a judicial warrant based on probable cause that the cars and boats are subject to forfeiture. However, the FBI cannot pursue the house or business because real property may never be forfeited administratively.
Operating under strict deadlines and filing requirements, the FBI must begin its administrative forfeiture process by providing notice to Mr. Slick, and to anyone else with a potential interest in the property, in a newspaper of general circulation. If Mr. Slick declines to file a claim contesting the forfeiture within the prescribed time period, the agency completes the administrative procedures by entering a declaration of forfeiture. If Mr. Slick decides to file a claim, the government has two options: civil and criminal forfeiture.
Criminal Forfeiture
Criminal forfeiture is referred to in legal jargon as an in personam action, because it is pursued as part of a criminal case against one or more persons, and the forfeiture of assets is considered to be part of the punishment for the crime, along with any jail time a court might impose. Criminal forfeiture requires the government to obtain a criminal conviction as the basis for forfeiting property. Only the defendant’s interest can be forfeited in a criminal case because criminal forfeiture is part of the defendant’s sentence. In our hypothetical situation, if the government decided to pursue criminal forfeiture against Mr. Slick, the government would bring a case captioned United States v. John Slick, and the criminal indictment or other charging document would contain a forfeiture allegation identifying the property that the government seeks to forfeit. In addition, because a criminal forfeiture order is an in personam judgment against the defendant, the court can order the defendant to pay a money judgment or to forfeit substitute assets not implicated in the crime if the directly forfeitable assets are no longer available.
Continuing with our example, in the criminal case against Mr. Slick, the government may pursue a criminal forfeiture by including the business, bank accounts, houses, cars, and boats in the forfeiture allegations listed in the criminal indictment. If Mr. Slick pleads guilty before the case goes to trial, it is important that at least one of the offenses that he pleads guilty to supports the forfeiture. If Mr. Slick goes to trial, and the government obtains a guilty verdict, a second phase of the trial takes place. In this second, forfeiture phase of the criminal trial, the government bears the burden of proving the connection between the property and the defendant’s criminal conduct. This is sometimes referred to as a bifurcated trial, and the reason for this two-step process is simple. Whereas the government has to prove Mr. Slick’s guilt beyond a reasonable doubt, it only has to prove the nexus between the property and the crime by a preponderance of evidence. If the government meets its burden, the court grants a preliminary order of forfeiture for the government as to Mr. Slick’s interest in the property.
However, the forfeiture is not complete until the court commences an ancillary hearing to address the interests of any third parties who may have an interest in the specific property forfeited. The ancillary hearing is essentially a quiet title action in which the court determines what portion of the property is forfeitable as to the defendant and what property is not forfeitable because of the interest of a third party petitioner. Once any third-party claims are resolved, the court will enter a final order of forfeiture, which transfers title of Mr. Slick’s property to the government.
Civil Forfeiture
The government may also proceed by way of civil forfeiture. Like criminal forfeiture, civil forfeiture is a judicial process, however, unlike criminal forfeiture, it does not require a criminal conviction. In legal jargon, civil forfeiture is sometimes referred to as an in rem action, because it is an action filed against the property itself, rather than a person (rem means property in Latin). Consequently, if the government were pursuing a civil forfeiture action against John Slick’s home located at 1234 Main Street, No Where, USA, the case would be captioned United States v. 1234 Main Street, No Where, USA.
Civil forfeiture is considered remedial rather than punitive in nature, because the goal of civil forfeiture is not punish someone, but to remedy harm caused to society by the criminal activity. Under well established principles of U.S. law, forfeited property is considered to be the property of the government at the time the crime was committed. Much like the forfeiture phase of a criminal trial, the purpose of the civil trial is to establish title to the property. Since the forfeiture action is against the property and not the defendant, it is limited to property that is traceable to the offense, that facilitated the offense, or that was involved in money laundering.
Returning to our fraud case involving Mr. Slick, the government, as the plaintiff, may file a civil complaint against his business and the assets acquired by Mr. Slick during the time period that he operated his Ponzi scheme. Mr. Slick, the claimant, must file claims to the property and answer the forfeiture complaint within a prescribed timeframe. As in any other civil case, the civil forfeiture case moves through discovery, motions practice, and ultimately trial by a judge unless a jury trial is requested. Finally, during the proceedings, third-party claims must be litigated before the court will enter a judgment for the government.
Part II — Disposition of Forfeited Assets
Forfeiture has become an indispensible tool for victims in the recovery and preservation of illicit gains arising from financial crimes such as fraud, embezzlement, and theft. Under the Civil Asset Forfeiture Reform Act (CAFRA) of 2000, the Department of Justice has the authority to return forfeited assets to victims of any offense that gave rise to forfeiture. Accordingly, forfeited assets may be returned to victims of all offenses for which a related civil or criminal forfeiture order is obtained. Using these powers, the department has already returned over $1 billion to victims in the first half of FY2012.
The nature of modern fraud schemes often poses legal challenges. Returning to our example, the government has successfully forfeited Mr. Slick’s assets, but its work is far from complete. As the criminal investigation and case proceeds, the government learns that Mr. Slick defrauded 2,000 victims in his Ponzi scheme. In addition, since the government brought a criminal case against Mr. Slick, his business, which also conducted some legitimate work, has fallen on hard times and he has filed for Chapter 11 bankruptcy. The victims, creditors, and non-creditors all want Mr. Slick’s assets so that they can recover their losses. The bankruptcy trustee wants to fulfill his fiduciary responsibility to marshal all the assets of Mr. Slick so that creditors and others can recoup as much of their loss amounts as possible. This raises a number of important questions. Is there a process for handling the return of forfeited assets to victims? How does the government handle the distribution of forfeited assets when there is also a bankruptcy proceeding? What is the interplay between asset forfeiture and bankruptcy? How can we successfully work together to meet our statutory and fiduciary obligations?
The Victim Asset Recovery Program
The vehicle through which the Department of Justice ensures that return of forfeited assets to victims is the Victim Asset Recovery Program (VARP). The purpose of VARP is to maximize the amount of forfeited money that can be returned to victims of crime. VARP is carried out by a dedicated team of experienced professionals, including attorneys, accountants, auditors, and claims analysts in the Asset Forfeiture and Money Laundering Section (AFMLS), which is a part of the Department’s Criminal Division. VARP has successfully used its specialized expertise to efficiently convert forfeited assets into victim recoveries in hundreds of cases. With its expertise and experience in handling these complex cases, VARP is uniquely equipped to maximize value for individual victims while ensuring fairness to all victims.
Types of Transfers to Victims
Under VARP there are two primary procedures that the government uses to return forfeited assets to victims: remission and restoration. Remission refers to the process by which the attorney general exercises discretion to use forfeited assets to provide a monetary payment to persons who have incurred a monetary loss from the offense underlying the forfeiture. Restoration is the process by which the attorney general exercises discretion to apply forfeited assets in satisfaction of restitution that a court has imposed against a criminal defendant. Restitution is an equitable remedy that courts often impose against defendants at sentencing in order to make crime victims whole and prevent criminal defendants from benefiting from the fruits of their crimes.
Although both of these transfers are discretionary, the attorney general has issued specific guidelines that require prosecutors to use asset forfeiture for the recovery of assets to victims of crime, as permitted by law, whenever possible.
Remission
The attorney general or the seizing agency may transfer forfeited property to a victim of a crime underlying the forfeiture through a process known as remission. Petitions for remissions, or requests by victims to receive a portion of forfeited assets, may be pursued with VARP if the assets have been forfeited through a criminal or civil judicial proceeding. Where assets have been subject to administrative forfeiture, the seizing agency is responsible for adjudicating remission petitions.
Remission is available to those who are “victims,” a term which under governing regulations means any person who has suffered a specific and identifiable pecuniary loss as a direct result of the crime underlying the forfeiture or a related offense. Persons include individuals, partnerships, corporations, joint business enterprises, estates, or other legal entities capable of owning property. However, a person cannot qualify as a victim if he/she:
Knowingly contributed to or benefited from the offense underlying the forfeiture or was willfully blind to it; or
Has recourse to other reasonably available assets or compensation; or
Seeks recovery for torts or physical injuries associated with the offense that are not the bases for the forfeiture.
Following the seizure or forfeiture of the property, the Department of Justice in cooperation with the investigating agency, identifies all potential victims and notifies them of the opportunity to file a petition. Victims known by the government are notified by mail. In addition, the department notifies unknown victims through newspaper publications and an Internet website set up specifically for this purpose.
A successful petition requires documentary evidence demonstrating the specific monetary loss suffered by the victim and the date the loss occurred. Acceptable evidence of loss may include cancelled checks, receipts, and invoices. The department and the investigating agency may also use records seized during the investigation to assist in substantiating the victim’s loss. In calculating pecuniary loss, any money returned to the victim separate and apart from the request must be accounted for and deducted. Losses that cannot be compensated through the remission process include:
Losses not supported by evidence;
Losses indirectly resulting from the underlying offense or a related offense;
Interest forgone; and
Collateral expenses (i.e., attorneys’ fees and investigative expenses) incurred to recover lost property.
When the forfeited funds are insufficient to fully compensate all victims who file a petition, the funds are generally distributed on a pro rata basis in accordance with the amount of loss suffered by each victim. For example, if the forfeited funds cover one-half of the victims’ total losses, each victim receives 50 percent of his/her actual pecuniary loss.
The government can deduct administrative costs incident to the forfeiture, sale, or other disposition of the property from the amount available to the victims. The remaining balance is distributed to the victims. Victims have priority over all law enforcement requests for equitable sharing.
Finally, if a remission petition is denied, a petitioner may submit a request for reconsideration within 10 days of receipt of the denial notification letter. Reconsideration requests are reviewed by an official who did not decide the original petition.
Restoration
A request to apply forfeited funds to a restitution order through restorationmust be initiated by the prosecutors responsible for the underlying case. Based on this request, VARP will transfer forfeited funds to a court for payment of restitution to the victim of a criminal offense. Forfeited funds may be applied to the restitution order if no other funds are available to fulfill the defendant’s restitution obligation. Victims may only receive funds through this process if they would be eligible for remission, i.e., if they are considered victims under the remission guidelines, suffered a specific monetary loss directly attributable to the crime and the losses are otherwise compensable.
Using this alternative process eliminates the need for each victim to file a petition for remission, and can lead to more efficient payment of funds to victims. This is particularly beneficial in large multiple-victim cases.
If the request for restoration is denied or never sought by the prosecutor, a person claiming losses as a victim may still request direct transfer through remission.
Which Process to Use–Restoration or Remission?
It is always the goal of the government to maximize the return of forfeited assets to the victims of the case in the most efficient and cost-effective manner possible. If the government is able to successfully work with the court to identify Mr. Slick’s 2,000 victims and their loss amounts in a restitution order, then proceeding with the restoration is preferable. If Mr. Slick is ordered to pay $40 million in restitution for the victims’ loss amounts and the government forfeits $20 million, then the transfer of the assets to the victims will be pro rata distribution.
On the other hand, if there is no restitution order or there are problems with the restitution order (e.g., not all the victims are identified), the government will pursue remission to return the forfeited assets to the victims. The government will send notice to the victims, will collect and analyze the victim petitions to verify the victim and the loss amounts, and will make a determination for each petition. As with remission, if the loss amounts for Mr. Slick’s Ponzi scheme total $40 million and the government forfeits $20 million, then the transfer of the assets to the victims will be pro rata distribution.
Part III — Interplay between Forfeiture and Bankruptcy Proceedings
Bankruptcy and asset forfeiture are rooted in two distinct and separate areas of law with divergent goals. Bankruptcy law is designed to effect an orderly unwinding of affairs when a business is insolvent. The bankruptcy process is well suited to sift through competing claims of creditors, and works best in ensuring recovery where the victims of a crime are composed of competing classes of creditors. The bankruptcy process is poorly suited to dealing with crimes involving broader classes of victims. In contrast, forfeiture, and the associated means of returning assets to victims described above, seek to compensate all crime victims–not just various classes of creditors–on a pro rata basis.
Consequently, when these two distinct proceedings intersect, how can we work together to accomplish our respective goals?
Cooperation Agreements
Cooperation agreements between the bankruptcy trustee and the government regarding the allocation and distribution of assets have proven to be very successful. These agreements are important because they require the parties to discuss, identify, and allocate assets between the two proceedings; to determine which proceeding is most effective in acquiring and liquidating assets for distribution; and to coordinate the distribution of assets between the two proceedings so that no one receives a double recovery, or more than their fair share.
In assessing Mr. Slick’s assets, a cooperation agreement could effect the following allocation and distribution of assets:
To the bankruptcy court: transferring the business and its assets to the bankruptcy trustee for liquidation and distribution to the creditors since Mr. Slick was conducting legitimate business along with his criminal activity. Generally, the government would have to expend significant resources and time to trace and prove the fraud proceeds going into the business.
To the government: retaining the directly traceable assets of the fraud proceeds for distribution to the broader class of victims. These assets would include the Mr. Slick’s houses, cars, boats, and personal bank accounts.
It is important to note that each case is unique and fact specific when drafting a cooperation agreement. One size does not fit all and each agreement must be customized to address the particular assets, evidence to support the criminal offenses, and petitioners in each case.
Conclusion
Despite separate and distinct bodies of law and underlying principals, there are important similarities in the bankruptcy and forfeiture proceedings that make cooperation important when there is overlap. First and foremost, prosecutors and bankruptcy counsel both have an obligation to uphold their respective statutory obligations and to serve the claimants and petitioners in their respective proceedings. If unnecessary litigation results in costly fees, which ultimately diminishes the assets available for distributions, then all victims lose. It would be a tragedy to compound the injustice that occurred through the initial fraud with legal battles that pit victims against one another. Second, there are fundamental principles of fairness and equity that guide both bankruptcy and forfeiture proceedings. As a general rule, both processes seek to make a fair and equitable distribution among the respective claimants, and to prevent outcomes which result in some claimants receiving more than their fair share of a limited pie. This all goes to say that when we work in concert, everyone benefits.
Are food trucks the underdog of the food industry or are they a force to be reckoned with? In recent years, food trucks have been hitting city streets in record numbers. This trend is driven, not only by the food industry’s desire to provide new and innovative dining options, but by individuals’ desire to achieve economic independence. For many, mobile vending is an entry point to entrepreneurship and a way to establish a living.
Social media tools, such as Facebook and Twitter, have greatly impacted the way that many food trucks market to customers. Food trucks rely almost exclusively on social media to advertise their brand, maintain customer relationships, and increase their accessibility. It is now possible for a food truck to tweet locations in advance so that customers can be waiting when the trucks arrive.
The rise in popularity of food trucks has not gone unnoticed. Opponents have attacked the mobile vending industry by arguing that food trucks are unfairly stealing customers away from brick-and-mortar businesses. To many opponents’ delight, various cities have imposed a myriad of regulations on food trucks. In some cases, these regulations make mobile vending an impossible or unprofitable business. The purpose of this article is to provide a brief general overview of the types of regulations imposed on mobile vending operations as well as to highlight some recent developments surrounding these regulations.
Overview of Mobile Vending Regulations
Food truck operators must comply with a variety of regulations. Not surprisingly, food truck operators are typically subject to a variety of state and local health and food safety regulations including (1) approval of food truck design, (2) approval for in-truck cooking equipment/configuration, (3) vending permits, (4) requirement for food truck personnel to obtain food safety certification, (5) periodic health inspections and (6) food safety requirements for depots where food stocks are replenished. More controversial, however, are local regulations that dictate how, where and when food trucks can sell food. These types of sale regulations include:
Public Property Bans. More than 10 major cities ban vending on public property, such as on streets and sidewalks. Vendors subject to such bans must contract with private property owners to vend on their property.
Restricted Zones. Many cities restrict the areas in which food trucks may operate. Restricted zones often include potentially lucrative areas, such as downtown commercial districts.
Proximity Bans. Proximity bans limit how close street vendors can park to certain types of businesses, typically brick-and-mortar restaurants. Proximity bans address the complaints of certain businesses who do not wish to have food trucks park near their place of business.
Stop-and-Wait Restrictions (Ice Cream Truck Rules). A handful of cities make it illegal for food trucks to stop and park in order to wait for customers. Instead, food trucks must be flagged down by a customer before they can park and serve the customer. Stop-and-wait restrictions make it difficult for food trucks to establish regular stops and develop relationships with customers.
Duration Restrictions. Food trucks that are allowed to stop and wait for customers may be limited in the amount of time they can remain in one spot. For instance, in Chicago, a food truck may not sell food for more than two hours on any one block.
Recent Developments in the Mobile Vending Industry
Lawsuit Against the City of El Paso
In Castenada v. City of El Paso, No. 3:11-CV-00035-KC (W.D. Tex) (Jan. 26, 2011), four food truck vendors sued the City of El Paso’s regulations over a regulation that banned food trucks from operating within 1,000 feet of restaurants, grocers, and other food-service establishments. These vendors argued that the regulation made it nearly impossible to operate profitably anywhere within El Paso. As a result, many mobile vendors in El Paso faced the possibility of losing their primary source of income. The food vendors argued that the regulation’s only purpose was to protect established businesses, which is not a legitimate government interest that would allow the government to infringe upon the constitutional rights of food vendors. As a result of the lawsuit, El Paso agreed to repeal the regulations.
California Bill Prohibiting School Trucks Near Schools
A proposed California bill recently sparked intense debate over the mobile vending industry. (California Assembly Bill No. 1678.) The bill, spearheaded by Assemblyman Bill Monning, would have prohibited food trucks from vending within 1,500 feet (approximately three blocks) of any elementary, middle, or high school. Opponents of the bill argued that it would eliminate the food truck industry in populated urban areas, where almost the entire city is within 1,500 feet of a school. On the other hand, supporters argued that the presence of mobile food trucks at schools would undermine state efforts to establish nutritious school food programs. On March 29, 2012, after intense pressure from industry groups, Monning released a statement taking the bill out of consideration.
City of Chicago Regulations
The food truck industry has thrived in cities like Los Angeles, New York, San Francisco, and Austin. This is not the case in Chicago where food trucks are subject to a wide array of legal restrictions imposed by the city. These restrictions include prohibitions on preparation of food on a truck or cart, serving customers before 10:00 a.m., and stopping within 200 feet of a restaurant. A bill, which was introduced in the city in June 2011, would lift the ban on food preparation in mobile food vehicles. Mayor Rahm Emanuel originally supported the bill but has recently equivocated on his support. The bill has been tied up in various committees for nearly a year and its future is uncertain at this point.
Impact of Regulating the Mobile Vending Business
Supporters of the mobile vending industry view food trucks as an avenue to entrepreneurship and a way to provide consumers with innovative products. Opponents, on the other hand, cite two primary arguments as reasons for eliminating the industry: health concerns and unfair competition to brick-and-mortar restaurants. For instance, critics of the industry question whether food can be prepared safely and whether health regulations can be properly enforced on a food truck.
Health concerns can be addressed by appropriate regulations. The real issue is whether food trucks unfairly steal customers from brick-and-mortar restaurants. This issue has become a political football in a number of municipalities as politicians attempt to regulate to protect brick-and-mortar restaurants that often have political clout and generate significant sales tax revenues. On the other side, civil liberty groups have taken up the cause of the food truck vendors and have become emboldened by their successful litigation in El Paso. In light of these competing interests, we expect that the regulation of food trucks will continue to generate controversy and litigation. Hopefully, the result will be that regulations strike a balance between fostering entrepreneurship and protecting the interests of those with significant investments in established businesses.
The Delaware Limited Liability Company Act (the LLC Act) does not expressly provide that managers of Delaware limited liability companies (LLCs) owe the common law fiduciary duties of care and loyalty that apply to the actions of directors and officers of Delaware corporations. However, in allowing fiduciary duties to be waived or eliminated, the LLC Act provides: “To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement . . . .” 6 Del. C. § 18-1101(c). The LLC Act also permits the LLC agreement to exculpate managers for liability for breaches of duties, including fiduciary duties. 6 Del. C. § 18-1101(e). Some commentators and practitioners take the position that such fiduciary duties must exist as a matter of law for there to be something to restrict or eliminate by contract. Others, focusing more on section 18-1101(b)’s announcement that “[i]t is the policy of this chapter to give the maximum effect to the principle of freedom of contract,” contend that an LLC agreement must provide that managers owe fiduciary duties for them to exist.
In the most extensive discussion of the issue by a Delaware court to date, in Auriga Capital Corporation v. Gatz Properties, LLC, __ A.3d __, 2012 WL 361677 (Del. Ch. Jan. 27, 2012), the Delaware Court of Chancery found that, unless eliminated or restricted in the LLC agreement, managers of LLCs owe default fiduciary duties. Given Delaware Chief Justice Myron T. Steele’s writings on the subject off the bench, however, it is possible that a majority Delaware Supreme Court will not reach the same conclusion if the issue is presented on appeal.
In this article, we will: (1) address the Delaware Supreme Court’s most recent decision on the issue pre-dating Auriga Capital; (2) analyze Chancellor Strine’s opinion in Auriga Capital; and (3) summarize Chief Justice Steele’s writings on this topic.
Delaware Supreme Court Has Not Ruled on the Issue
In William Penn Partnership v. Saliba, 13 A.3d 749 (Del. 2011), the defendant managers of an LLC appealed from the Court of Chancery’s decision that the managers breached their fiduciary duties. William Penn Partnership managed Del Bay Associates, LLC, and William and Bryce Lingo managed William Penn. William Penn, which was owned by William and Bryce Lingo and their relatives, owned a 50 percent interest in Del Bay. The Lingos caused Del Bay to sell the Beacon Motel to an entity in which they had a 40 percent stake and controlled the board of directors. Although the Lingos did not control enough of Del Bay to cause the sale alone, they were able to obtain support of another member of the LLC. During the sales process the Lingos provided misinformation to members, withheld other information from members, and imposed an artificial deadline. Following trial, the Court of Chancery found that the Lingos were self-interested in the transaction, and thus had the burden of proving that the transaction was entirely fair. The court also found that the Lingos breached their fiduciary duty of loyalty because they could not prove that the self-interested transaction was entirely fair.
On appeal, the Lingos did not challenge the assertion that they owed fiduciary duties. Preferring to draft a narrowly tailored opinion that addressed only the issue before it, the court avoided finding that such duties were owed. Writing for the court, Chief Justice Steele stated that “[t]he parties here agree that managers of a Delaware limited liability company owe traditional fiduciary duties of loyalty and care to the members of the LLC, unless the parties expressly modify or eliminate those duties in the operating agreement.” Ultimately, based on the facts of the case and the parties’ agreement that fiduciary duties were owed, the Delaware Supreme Court found that it was impossible for the Lingos to prove the fair dealing prong of entire fairness review because of the misleading and incomplete disclosures to the other members of the LLC.
Court of Chancery: Managers of LLCs Owe Default Fiduciary Duties
Although the Court of Chancery previously has held that managers of LLCs owe fiduciary duties in the absence of elimination in the LLC agreement, in his opinion issued last month in Auriga Capital, Chancellor Strine offered the court’s most comprehensive analysis to date of why managers of LLCs owe fiduciary duties under Delaware law. The court systematically lays out the case for LLC managers owing fiduciary duties based on: (1) equitable principles incorporated into the LLC Act; (2) a textual analysis of section 18-1101 and its drafting history; and (3) two policy reasons.
First, the court found, pursuant to the LLC Act, that equity governs situations not specifically addressed by the LLC Act. Specifically, section 18-1104 of the LLC Act provides that “[i]n any case not provided for in this chapter, the rules of law and equity, including the law merchant, shall govern.” The court acknowledged that the LLC Act does not expressly state that managers of LLCs owe fiduciary duties by default. However, as the court explained, “[i]n that respect, of course, the LLC Act is not different than the [Delaware General Corporation Law], which does not do that either.” Despite the absence of language in the DGCL establishing fiduciary duties, the Delaware Supreme Court found that equitable fiduciary duties still apply to the actions of directors of Delaware corporations. Furthermore, Chancellor Strine found that “unlike in the corporate context, the rules of equity apply in the LLC context by statutory mandate, creating an even stronger justification for application of fiduciary duties grounded in equity to managers of LLCs to the extent that such duties have not been altered or eliminated under the relevant LLC agreement.” Under Delaware law, a fiduciary relationship arises when a person “reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.” Traditionally, equity has found that corporate directors, trustees, and general partners meet this definition. The court held that managers of LLC, much like directors of corporations, have discretion to manage the company on behalf of others. Consequently, the relationship is of a fiduciary rather than commercial nature.
Second, Chancellor Strine determined that the text of section 18-1101 and its drafting history weighed in favor of finding that managers owe fiduciary duties as a default matter. In Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002), the Delaware Supreme Court questioned whether the fiduciary duties of a general partner could be fully eliminated by the partnership agreement under the statutory text of the LLC Act at the time. In response, the General Assembly revised both the Delaware Revised Limited Uniform Partnership Act and the LLC Act to expressly provide that fiduciary duties may be restricted or eliminated. According to Chancellor Strine, if the General Assembly intended for there to be no default fiduciary duties, it would have so provided at the time of the revisions to the LLC Act following Gotham Partners. In other words, the General Assembly could have legislated a default position of no fiduciary duties and permitted members of LLCs to agree contractually that managers owe fiduciary duties. To the contrary, the General Assembly left in place section 18-1104’s equitable default, created a provision in section 18-1101(c) that clearly permitted the elimination of fiduciary duties by contract, and permitted the exculpation of liability through section 18-1101(e). As the court rhetorically asks: “why would the General Assembly amend the LLC Act to provide for the elimination of (and the exculpation for) ‘something’ if there were no ‘something” to eliminate (or exculpate) in the first place?”
Third, Chancellor Strine offers two policy reasons weighing against a finding that managers of LLCs do not have fiduciary duties. “The first is that those who crafted LLC agreements in reliance on equitable defaults that supply a predictable structure for assessing whether a business fiduciary has met his obligations to the entity and its investors will have their expectations disrupted.” The court acknowledged that the implied covenant of good faith and fair dealing would remain since section 18-1101(c) prohibits its elimination, but noted that the implied covenant is not and should not be a substitute for traditional fiduciary duties. Citing the Delaware Supreme Court’s recent opinion of Nemec v. Shrader, 991 A.2d 1120 (Del. 2010), Chancellor Strine explained that “the implied covenant is not a tool that is designed to provide a framework to govern the discretionary actions of business managers acting under a broad enabling framework like a barebones LLC agreement,” and that it may only be applied in situations that could not be anticipated at the time of drafting. By contrast, fiduciary duties may protect against manager abuse of discretion legally granted by the LLC Act or contract and that could have been anticipated at the time of the LLC agreement. Analyzing the second policy reason, the court explained that “a judicial eradication of the explicit equity overlay in the LLC Act could tend to erode our state’s credibility with investors in Delaware entities.” According to the court, a reasonable investor would have concluded, prior to investing in a Delaware LLC, that LLC managers owe default fiduciary duties because: (1) section 18-1104 provides an equitable overlay to the LLC Act and (2) the General Assembly would not have provided for the elimination of fiduciary duties in section 18-1101(c) if such duties did not exist.
Chief Justice Steele’s Article and Recent Presentations on LLC Managers’ Duties
Chancellor Strine’s opinion in Auriga Capital explains the statutory and equitable rationale for finding that managers of Delaware LLCs, unless restricted or eliminated by the LLC agreement, owe fiduciary duties. The question remains: will the Delaware Supreme Court adopt the Chancellor’s logic? As discussed above, in William Penn, the Supreme Court only assumed without deciding that the managers of the LLC at issue owed fiduciary duties because the parties assumed that to be the case. Therefore, the Delaware Supreme Court is not bound by its own precedent to find that managers owe fiduciary duties. In fact, it would appear that there may be at least one vote on the five-member Delaware Supreme Court to find just the opposite.
In his 2007 article Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1 (2007), Delaware Chief Justice Myron T. Steele concluded that managers of Delaware LLCs should not owe traditional fiduciary duties unless the parties to the LLC agreement agree that fiduciary duties exist. Chief Justice Steele faults Delaware courts for turning to the law governing corporations by analogy rather than to the contractual language of the LLC agreement. In his article, the Chief Justice does not address the equitable overlay that Chancellor Strine references from section 18-1104. Rather, the Chief Justice focuses on section 1101(b)’s instruction that “[i]t is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” According to the Chief Justice, “[c]ourts should recognize the parties’ freedom of choice exercised by contract and should not superimpose an overlay of common law fiduciary duties, or the judicial scrutiny associated with them, where the parties have not contracted for those governance mechanisms in the documents forming their business entity.”
More recently, on October 11, 2011, Chief Justice Steele participated in a symposium sponsored by the Delaware State Bar Association entitled “Hot Topics on Delaware Limited Liability Companies and Limited Partnerships.” Chief Justice Steele spoke and provided materials called “Eliminating Fiduciary Duties in LLC Formation Documents,” which in part addressed the issue of whether managers of LLCs owed default fiduciary duties if the LLC agreement is silent on the issue. Chief Justice Steele proposed to let the parties decide the issue by contract. According to the Chief Justice, “[c]ourts should not imply traditional fiduciary duties when LLC agreements are silent.” He offered several reasons for this view. First, he noted that LLCs did not exist at common law and fiduciary duties derive from common law. Consequently, the Chief Justice describes fiduciary duties and LLCs as “strange bedfellows.” Second, again emphasizing the freedom of contract provided in section 18-1101(b), Chief Justice Steele suggested that the parties could contract for fiduciary duties if they so desired, and that “courts should assume the parties did not want them to apply at all” if they are not addressed in the LLC agreement. He also suggested that the General Assembly intended to leave it to the parties to decide by not taking a formal position on the issue. Third, the Chief Justice noted that the implied covenant of good faith and fair dealing provides an “immutable protective backstop.” Ultimately, Chief Justice Steele concluded that this approach offered certainty and predictability, encouraged stronger management, and arguably provided more value to participants in the LLCs because of the enhanced flexibility. The Chief Justice also noted that he was not speaking for the Delaware Supreme Court and that he was still open to being persuaded if and when an actual case on the issue reaches the court.
CML V, LLC v. Bax and the Equitable Overlay of Section 18-1104
The Delaware Supreme Court’s recent opinion in CML V, LLC v. Bax, 28 A.3d 1037 (Del. 2011), which Chief Justice Steele authored, is also relevant to the analysis. In CML, the Court of Chancery found that a creditor of an insolvent LLC does not have standing to bring a derivative claim because of specific language in the LLC Act. By contrast, a creditor may bring a derivative claim against an insolvent corporation. On appeal, CML argued, in part, that a derivative claim was not prohibited by the LLC Act because of the equitable overlay found in section 18-1104, the same provision on which Chancellor Strine relies, in part, in Auriga Capital. In CML, citing to section 18-1104, the Delaware Supreme Court found that the “General Assembly expressly acknowledged in the text of the LLC Act that common law equity principles supplement the Act’s express provisions.” The supreme court went on to explain, however, that “what this means is that where the General Assembly has not defined a right, remedy, or obligation with respect to an LLC, courts should apply the common law. It follows that if the General Assembly has defined a right, remedy, or obligation with respect to an LLC, courts cannot interpret the common law to override the express provisions the General Assembly adopted.” The court found that equity could not extend derivative actions to creditors of insolvent LLCs, in part, because the LLC Act expressly limited such claims to members and assignees of LLCs. In contrast, in Auriga Capital, Chancellor Strine found that the LLC Act, which does not eliminate fiduciary duties, left room for equity to apply fiduciary duties to LLC managers when the LLC Agreement does not restrict or eliminate them. It is unclear if the Delaware Supreme Court would limit the reach of section 18-1104 and equitable principles on the ground that the LLC Act already addresses the question of default fiduciary duties through its express declaration to “give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”
Key Takeaways from the Current State of the Law
Although there is some uncertainty over the future of default fiduciary duties for managers of LLCs in Delaware based on the absence of a definitive opinion from the Delaware Supreme Court, members and managers of LLCs can draw certain conclusions about the current state of the law in Delaware. As always, because Delaware honors the freedom of contract, parties to LLC agreements are best advised to make their positions on fiduciary duties clear in the LLC agreement. However, as Chancellor Strine noted in Auriga Capital, “few LLC agreements contain an express, general provision that states what fiduciary duties are owed in the first instance.” It is more typical for agreements to assume that such duties exist and then to modify those duties. Moreover, it is of course easy for the authors of this article to advise others to draft agreements with clear provisions expressly adopting, restricting, or eliminating fiduciary duties since our advice is divorced from the complicated reality of the negotiating table. At times the uncertainty inherent in an agreement is the result of negotiations designed to get to “yes,” where many competing considerations may trump the virtues of having clauses explicit as to the existence and scope of fiduciary duties. In other situations where counsel are not involved at the time of the LLC’s formation, parties often use bare bones LLC agreements and do not consider whether they desire fiduciary duties to apply. Accordingly, despite the freedom to contract as to the existence and scope of fiduciary duties, some parties will continue to execute LLC agreements silent as to fiduciary duties. In those situations, it is important to remember that, to date, the Delaware Supreme Court has neither adopted nor rejected Chief Justice’s Steele’s position of no default fiduciary duties for LLC managers. Therefore, in the wake of Auriga Capital, managers and investors in LLCs with LLC agreements that are silent as to fiduciary duties should proceed under the assumption that managers owe the traditional corporate fiduciary duties of care and loyalty.
The press is full of articles concerning residential real estate foreclosures. Sometimes questions arise in these judicial and non-judicial proceedings concerning ownership and enforcement of the notes and related mortgages. Uniform Commercial Code Articles 3 and 9 (and related definitions in Article 1) address some of the issues that have come up in these proceedings. The litigants and the courts considering these matters sometimes do not recognize the applicability of the UCC or may have difficulty applying the rules of the UCC. See, e.g., U.S. Bank v. Ibanez, 458 Mass. 637, 941 N.E.2d 40 (2011).
The Permanent Editorial Board for the Uniform Commercial Code has just issued a report (Report) to explain the application of UCC provisions that govern selected aspects of these matters and how those provisions apply to common fact patterns in this area. The PEB Report addresses how the UCC governs the following matters:
Who is the person entitled to enforce a mortgage note?
How is the transfer of a property interest (ownership or a security interest to secure an obligation) in a mortgage note accomplished?
What effect does the transfer of a mortgage note have on the related mortgage?
How can a person enforce a mortgage note by foreclosing non-judicially if the person does not have a recordable assignment of the mortgage?
Procedure
The PEB prepared and issued a draft Report for public comment in March 2011. The PEB received comments and prepared revisions to the Report. The final Report was issued in mid-November. It is available on the webpages of the two sponsors of the UCC, the American Law Institute (www.ali.org) and the Uniform Law Commission (www.uniformlaws.org).
During the course of the comment period, at least two courts cited the draft Report when considering issues addressed by the Report. See In re Jackson, 451 B.R. 24 (Bankr. E.D. Calif. 2011) and In re Veal, 449 B.R. 542 (9th Cir. BAP 2011). In each case the court held for the homeowner, concluding that the person seeking to enforce the particular mortgage note had not satisfied the relevant requirements of the UCC, as explained in the (draft) PEB Report.
What the Report Does Not Cover
The Report limits its discussion to selected UCC issues:
The Report states several times that the UCC governs the issues that it governs, but does not address issues of real property law.
The Report sometimes refers to the UCC’s use of other law in connection with the application of the UCC’s rules, for example agency law. In those circumstances, the Report notes the applicability of the other law (such as agency law) but does not discuss the content of the other law. In particular, where the UCC requires “possession” of a note to create certain rights, the Report observes that both Article 3 and Article 9 (with an assist from UCC § 1-103(b)) recognize that possession of the note can occur through an agent.
The Report’s discussion of Article 3 recognizes that Article 3 applies only to “negotiable instruments” as that term is defined in Article 3; the Report observes that if a mortgage note is not a “negotiable instrument,” the Report’s discussion of Article 3 issues does not apply to that mortgage note.
The Report’s discussion of Article 9 issues notes that Article 9 applies to all instruments, i.e., both negotiable and non-negotiable notes.
The Report does not address all issues that might arise under the UCC in this context, such as the possible status of a holder of a mortgage note as a holder in due course of the mortgage note and the effect that that status might have on possible defenses that the maker might be able to assert.
Who is Entitled to Enforce a Mortgage Note?
Article 3 employs the concept of a “person entitled to enforce” a note to determine the person to whom the maker of the note owes its payment obligation. UCC § 3-301. That person might or might not be the owner of the note (UCC § 3-203, Comment 1), but payment to that person discharges the maker’s obligation under the note. UCC §§ 3-412 and 3-602.
A person is the person entitled to enforce the note if any of the following is true:
The person is the “holder” of the note,
The person is in possession of the note, which was “transferred” to that person, but the person is not a “holder” of the note, and
The note has been lost or destroyed (or is unavailable for other reasons) and the person who had been in possession was a person entitled to enforce the note
These alternatives for becoming the person entitled to enforce the mortgage note are satisfied (or not) as follows:
The first alternative is satisfied only if the person (or its agent) has possession of the mortgage note and the mortgage note is payable or endorsed to that person or endorsed in blank.
The second approach also requires that the person (or its agent) has possession of the mortgage note. If the mortgage note is not payable to the person in possession or to bearer, then the person is not a “holder.” However, if the mortgage note was “delivered” to the person in possession “for the purpose of giving” that person the right to enforce the instrument, the second alternative applies.
The third alternative requires proof of the elements noted above, along with the terms of the mortgage note.
Transfer of Ownership
Unlike Article 3, Article 9 applies to interests in both negotiable and non-negotiable instruments. UCC § 9-102(a)(47). Article 9 applies to both a security interest in a mortgage note to secure an obligation and to the rights of a buyer of a mortgage note. UCC § 9-109(a)(1) and (3). Article 9 thus determines the requirements for an “effective” transfer of rights in those two situations. UCC § 9-203.
The requirements for an effective transfer of ownership (in the case of a sale) or a security interest to secure an obligation (in the case of a loan secured by the mortgage note) are straightforward:
Value must be given–this is typically satisfied by the payment of the purchase price in the case of a sale of a mortgage note and the promise to make a loan or the advance of the loan amount in the case of a security interest to secure an obligation. UCC § 1-204.
The seller or person creating the security interest to secure an obligation must have “rights” in the mortgage note–this too is usually easy to satisfy.
Generally, the seller or person creating a security interest to secure an obligation must “authenticate” a security agreement describing the mortgage note. UCC § 9-203(b)(3)(A). Whether the agreement covers the sale of the mortgage note or a security interest to secure an obligation, the agreement sufficiently describes the mortgage note if the agreement “reasonably identifies” the mortgage note. UCC § 9-108(a). For example, a description of mortgage notes by “category” or “type” is sufficient. UCC § 9-108(b)(2) and (3). (An oral (or other unauthenticated) security agreement is also possible in some circumstances. UCC § 9-203(b)(3)(B)).
If these requirements are satisfied, the buyer or lender with a security interest in a mortgage note to secure an obligation obtains a property interest in the note as owner or holder of the security interest to secure an obligation.
The Mortgage Follows the Note
The law in the United States has long followed the Mary’s Little Lamb rule–wherever the mortgage note goes the related mortgage is sure to follow. Restatement (Third) of Property (Mortgages) § 5.4. UCC § 9-203(g) codifies this rule for both sales of a mortgage note and a security interest in a mortgage note to secure an obligation. Further, perfection of a security interest in the mortgage note (whether in favor of a buyer or a lender with a security interest to secure an obligation) also perfects the security interest in the buyer’s or lender’s security interest in the seller’s or borrower’s rights in the mortgage. References to a “mortgage” in UCC § 9-203(g) include other types of consensual rights in real property to secure an obligation, such as a deed of trust. UCC § 9-102(a)(55).
Getting the Mortgage in the Secured Party’s Name
To save effort and money for all concerned, often a buyer of a mortgage note or a lender with a security interest in the mortgage note to secure an obligation will not record an assignment of the mortgage in the real estate records. As Article 9 makes clear, recording an assignment is not necessary for the buyer or lender to perfect its rights in the seller’s or borrower’s rights in the mortgage.
However, if the buyer or lender wants to foreclose, it may not have and may not be able to obtain the documents necessary to record the assignment in the real estate records, which may be necessary under local real estate law. Article 9 provides a procedure for the buyer or lender to record a document in the real estate records to reflect that assignment. UCC § 9-607(b).
Conclusion
The PEB Report describes the application of selected provisions of UCC Articles 3 and 9 to several key issues that may come up in connection with mortgage notes. There may well be additional UCC issues or issues arising under other law that also must be resolved, but the Report should help both practitioners and courts understand many of the issues that the UCC addresses in this area.
Each year, thousands of people flee persecution in their home countries and seek protection in the United States in the form of asylum. Applying for asylum in the United States requires an understanding of the laws of our country and familiarity with our legal procedures. Most applicants for asylum are financially strained and woefully unequipped to effectively represent themselves, making the need for pro bono representation in the field of asylum law especially crucial.
At major law firms, where practices are generally divided into either transactional or litigation groups, conventional wisdom holds that the work of representing asylum-seekers is best suited for litigators. After all, representing an asylum-seeker often involves traditional litigation skills, such as arguing a case in front of an adjudicator, writing a legal brief, and preparing a witness to testify.
However, there is much to be said about the unique skills developed by attorneys practicing in the transactional field that can be applied to pro bono work in asylum law. Such skills can render a transactional attorney uniquely well-position to serve as an outstanding advocate for an asylum-seeker, for whom legal representation could mean the difference between being allowed to live safely in this country or being returned to the arms of persecutors.
To be sure, there are certain skills that attorneys develop in either a transactional or litigation practice–including empathy, intellectual curiosity, excellent listening skills, integrity, and a devotion to high quality work product–that are essential when representing asylum-seekers. Nonetheless, the nature of work in a transactional field provides special training for several important characteristics, as discussed below.
Attention to Detail
We transactional attorneys are the detail attorneys. We are trained to find the single item of concern in the far corner of a page buried in a stack of agreements, and to know quickly how to make connections within seemingly distant aspects of a financing. Our eyes are sharp, and so is our passion for finding even the most insignificant of discrepancies, knowing that such may be the most vital aspect of a transaction.
This skill is a true advantage in asylum work. Because a case depends largely on an adjudicator’s determination of the applicant’s credibility, completing an application for asylum requires careful attention to detail. In determining credibility, immigration judges consider, among other things, the consistency between an applicant’s written or oral statements, the internal consistency of such statements, as well as any inaccuracies or falsehoods contained in the applicant’s statements, whether or not material to the asylum claim. So, while seemingly minor details of an application–for example, names of towns or approximate dates of events–may not be material to the specific events of an asylum-seeker’s persecution, any discrepancy has the potential to lead to a finding of non-credibility, and, in turn, to a denial of an asylum claim. Having an attorney with a keen appreciation for detail–who looks carefully over an application, as well as between the application, the written affidavit and the various supporting documents–can better ensure an applicant is presenting an accurate and consistent narrative in a way that will avoid an application being denied for otherwise insignificant reasons.
Cultural Understanding
In the increasingly global market place, more and more of our transactional representations require us to think and act across borders. As our clients and financial markets cross borders, transactional attorneys are increasingly gaining experience interacting and negotiating with clients and attorneys from across the globe. Law firms are also merging internationally, giving transactional attorneys more routine cross-cultural interaction. As a result, transactional attorneys today are developing a sensitivity to cultural, religious, and other differences, in a way that our colleagues in the litigation field may not.
Such expertise is precisely the type of skill that can have a positive impact in a pro bono asylum case. Asylum-seekers do not come to the United States from just one or two places. In fact, the top countries of origin in recent years have included China, Haiti, Colombia, India, Ethiopia, Egypt, and Somalia. In 2010, 148 different nationalities were represented among successful asylum cases in U.S. Immigration Courts. Accordingly, asylum-seekers speak a host of different languages and come from all walks of life. Asylum-seekers come to our country with varying concepts of social class relations, gender roles, and even the importance of date and time in defining events. Having an attorney who appreciates that such differences may exist and who is willing to find creative ways to address these differences can have an immeasurable impact on the outcome of a case.
Access to Business Expertise
In most transactional practices, attorneys work with clients over a long period of time. Our clients are in the world of business, and often have bodies of knowledge and expertise that can be put to excellent use in asylum cases. While relationships between attorneys and clients in the litigation realm may typically last only a brief amount of time, relationships in the transactional field are relatively longer-lasting. Especially at large law firms, clients in the transactional realm come to us for repeated transactions, and seek us out in between transactions as issues require attention.
The relationships we develop with business professionals can be of special use in an asylum case. Most observers agree that one of the most critical elements in a case can be identifying an expert witness who can help bring an added layer of credibility to an asylum-seeker’s testimony. Often times, it can be especially difficult for an asylum-seeker to identify and obtain the assistance of potential expert witnesses, while a transactional attorney may have much better access. Transactional attorneys in media law might find that their media clients can serve as excellent resources when taking on pro bono cases for journalists fleeing their countries because of their political opinions. Transactional attorneys in educational law may have developed relationships with individuals at universities, including professors and researchers, who could serve, or readily identify colleagues to serve, as expert witnesses in a variety of cases. In my field of public finance, many of my clients are hospitals. Many of my pro bono cases have involved instances of past physical abuse for which a medical evaluation was helpful in documenting past persecution. Several of my past pro bono clients have demonstrated symptoms of post traumatic stress disorder, for whom receiving professional mental health services has been critical. I have found that my relationships with transactional clients have helped me to identify medical professionals who can offer advice and support, including in the form of written affidavits or oral testimony. Such relationships can certainly make a difference, by providing corroboration for an asylum-seeker’s narrative and by providing victims of abuse with the treatment they desperately need.
The need for the services of pro bono attorneys in the field of asylum law is great, and such need cannot be met by our colleagues in the litigation field alone. Unlike the criminal justice system, there are no provisions made by the government to provide asylum-seekers with legal representation. Even in removal proceedings, which are held before an immigration judge, the Immigration and Nationality Act states that asylum-seekers may be represented by counsel but that such representation shall be at no expense to the government. Not surprisingly, the U.S. Department of Justice’s Executive Office for Immigration Review, which has oversight of the immigration court system, has stated that the large number of asylum-seekers appearing pro se is of great concern. In 2010, 57 percent of cases in immigration court were pro se, and in 2009, 60 percent of cases were pro se. Studies have found that having representation in court is the single most important factor affecting the outcome of the asylum-seeker’s case. Indeed, one recent study found that from January 2000 through August 2004, asylum-seekers with representation were granted asylum at a rate of 45.6 percent, compared with only 16.3 percent for pro seasylum-seekers over the same period.
Even for transactional attorneys worried about extending their pro bono practices outside of their transactional field, odds are they would ultimately feel satisfied with their pro bono representation of asylum-seekers. A 2009 report from the ABA on pro bono work looked in part at the types of pro bono engagements that attorneys take on. ( Supporting Justice II: A Report on the Pro Bono Work of America’s Lawyers (2009) .) The ABA found that while about 80 percent of pro bono attorneys carried out their representation in an area within the scope of their regular practice, only 27 percent of the attorneys who practiced in pro bono outside of their field of expertise indicated that such representation caused them any concern. This should provide comfort for transactional attorneys looking to step outside of their day-to-day practice and take on the challenge of representing an asylum-seeker.
So clearly there is a place for transactional attorneys to make a difference. With the unique talents and experiences that come from transactional work, transactional attorneys are well-positioned to make excellent and needed contributions to the field. The work of a pro bono attorney can truly make a life-altering difference for someone in need.
This is the Sixth Edition of the Corporate Director’s Guidebook. Since its initial publication in 1978, directors, business executives, advisors, students of corporate governance, and others have all come to rely on the advice and commentary in the Guidebook. Indeed, the Guidebook is the most frequently cited handbook in its field.
The primary purpose of the Guidebook is to provide concise guidance to corporate directors in meeting their responsibilities. The Guidebook focuses on the role of the individual director, in the context of providing advice about the duties and operation of the board and its key committees (audit, nominating and governance, and compensation). Although many director decisions and tasks occur against a legal backdrop, we emphasize the law only in limited instances and otherwise attempt to avoid legalisms.
The Fifth Edition of the Guidebook, published in 2007, assumed that certain legal reforms like the Sarbanes-Oxley Act were a baseline for director action and focused on company performance under the spotlight of investor interests. This Sixth Edition is being published in the wake of the 2007–2010 financial crisis and the resulting legislation, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). As a result, this edition emphasizes themes arising out of the crisis and important to all directors, particularly those in public companies.
The Sixth Edition explores the role of directors in overseeing both strategy and risk. Strategy and risk are interrelated, and directors cannot understand and guide strategy without also focusing on risk. Corporations must manage risks appropriately. Although not engaged in day-to-day risk management, directors are charged with its oversight.
Today, director decisions are subject to a much more significant level of public and shareholder scrutiny than ever before. To help directors engage in effective oversight and decision-making processes in the current environment, the Sixth Edition emphasizes the following:
Risk management and its role in company strategy and operations;
Executive compensation decision-making by compensation committees, with a focus on the links between compensation, performance, and risk;
Chief Executive Officer (CEO) succession planning and its relationship to strategy and risk oversight;
Enhanced shareholder activism and power, including the pressure for proxy access in director elections; and
New federal statutory and regulatory requirements that set forth legal baselines for boards and public companies.
The Sixth Edition also adds an appendix of corporate governance websites and blogs, as well as listings for associations, institutional investors, and other resources.
The Guidebook provides important information for directors of public companies, but it is also relevant to directors of all companies in understanding their duties and obligations. In short, it provides a concise guide to boardroom best practices for all directors. The Corporate Laws Committee hopes directors and their advisors will benefit from this Sixth Edition of the Guidebook.
Respectfully submitted,
A. Gilchrist Sparks, III
Chair
Corporate Laws Committee
CORPORATE LAWS COMMITTEE
The Corporate Laws Committee of the American Bar Association’s Section of Business Law is composed of active or former practicing lawyers, law professors, regulators, and judges with corporate law expertise from throughout the United States and Canada. In addition to the Corporate Director’s Guidebook and other scholarly writings, the Committee is responsible for the development of the Model Business Corporation Act.
The Model Act, first issued in 1950, has been adopted substantially in its entirety by more than thirty states in the United States and in important respects by many other states. The Model Act has played an important role in the development of corporate law in the United States and elsewhere.
The Committee serves as the permanent editorial board for the Model Act, reviewing, revising, and updating its provisions on a continuing basis. Moreover, the Committee publishes the Model Business Corporation Act Annotated, a comprehensive compilation of the Model Act and cases and authorities relevant to its provisions.
The roster of active Committee participants during the publication of the Guidebook’s Sixth Edition (including appointed members, consultants, and liaisons from other ABA committees) is listed below.
Frederick H. Alexander
Wilmington, DE
Claudia H. Allen
Chicago, IL
Stuart D. Ames
Miami, FL
Professor Stephen M. Bainbridge
Los Angeles, CA
Lawrence J. Beaser
Philadelphia, PA
Alan L. Beller
New York, NY
James H. Cheek, III
Nashville, TN
William H. Clark, Jr.
Philadelphia, PA
Richard E. Climan
East Palo Alto, CA
John P. Coffey
Bronxville, NY
Professor James D. Cox
Durham, NC
Professor Michael P. Dooley
Charlottesville, VA
Karl J. Ege
Seattle, WA
Professor Lisa M. Fairfax
Washington, DC
Margaret M. Foran
Newark, NJ
Diane Holt Frankle
East Palo Alto, CA
Mark J. Gentile
Wilmington, DE
Allen Cunningham Goolsby
Richmond, VA
———————
Holly J. Gregory
New York, NY
Carol Hansell
Toronto, Ontario
Whitney Holmes
Denver, CO
Mary Ann Jorgenson
Cleveland, OH
Eliot L. Kaplan
Phoenix, AZ
Stanley Keller
Boston, MA
Thomas J. Kim
Washington, DC
David B.H. Martin
Washington, DC
Michael R. McAlevey
Fairfield, CT
David C. McBride
Wilmington, DE
Thomas R. McNeill
Atlanta, GA
James P. Melican
Naples, FL
James C. Morphy
New York, NY
Patrick Pohlen
Menlo Park, CA
Steven A. Rosenblum
New York, NY
Kim K.W. Rucker
New York, NY
Professor Hillary A. Sale
St. Louis, MO
Larry P. Scriggins
Baltimore, MD
Marshall L. Small
San Francisco, CA
Laurie Smiley
Kirkland, WA
A. Gilchrist Sparks, III
Wilmington, DE
The Honorable Leo E. Strine, Jr.
Wilmington, DE
Tina S. Van Dam
Midland, MI
The Honorable E. Norman Veasey
Wilmington, DE
Robert M. Walmsley, Jr.
New Orleans, LA
Herbert S. Wander
Chicago, IL
James B. Zimpritch
Portland, ME
SECTION 1: OVERVIEW
This edition of the Guidebook, like its predecessors, explores the relationship of the board of directors to the CEO and other senior management officers as well as to shareholders. Directors are elected by the shareholders and have a duty to advance the interests of the corporation to the exclusion of their own interests. Shareholders do not have the right to manage the corporation. Instead, the board of directors oversees the business and affairs of the corporation and delegates to the officers the day-to-day operation of the enterprise. This book focuses on the balance in the allocation of rights and duties, emphasizing the ways in which directors of public corporations devote their time and experience to the strategy and oversight of the company’s business.
The book is geared to the individual directors of public companies, or those with public shareholders and a trading market for their shares. The Guidebook is, however, relevant to all corporate directors. It provides an overview or guide to the role of the board, the functions and responsibilities of the board, and the board’s structure, including committees and operations. The goal is to help directors be effective in fulfilling their duties to the corporation and in the boardroom.
Directors make many decisions on a regular basis. In doing so, they must apply their business judgment based on reasonably available material information and act in what they reasonably believe to be the best interests of the corporation. In some cases, a board may even make a decision, in good faith, knowing that a substantial percentage of shareholders might disagree with that decision.
In today’s world, most directors are “independent directors.” The key challenge for directors is to oversee the corporation’s activities and strategy by utilizing effective oversight processes and making informed decisions, without becoming day-to-day managers. In doing so, directors must be cognizant of their obligation to act free of conflicts and in what they perceive to be the best interests of all shareholders. This Guidebook helps directors meet that responsibility by explaining how they can exercise their oversight and decision-making responsibilities and by identifying the boardroom practices and procedures that support and promote effective director involvement.
Importantly, directors exercise their decision-making powers only by acting collectively, either as a board or as a board committee. Judgment, however, is exercised individually, and informed judgment requires individual preparation and participation, as well as group deliberation. Effective board oversight results from both group deliberation and from the recognition by an individual that a particular matter warrants further inquiry or action.
Corporations are creatures of the state in which they are incorporated. For corporate directors and the corporation itself, that means that the statutes and state court decisions of the state of incorporation will govern many corporate decisions and processes. The same is true of judicial decisions. Public corporations, however, are also subject to federal securities laws and regulations and the listing standards of the major securities markets. The Guidebook addresses the federal securities law regime and the listing standards that mandate specific governance processes. The Guidebook does not, however, address industry-specific federal or state regimes, such as, for example, regulations applicable to financial institutions or utilities.
Importantly, most directors are not lawyers, and, as a result, where appropriate, they should seek legal advice to ensure they satisfy legal requirements and properly support the board’s deliberative decision-making processes. Although not all corporations have an internal general counsel, for convenience, the Guidebook uses the term “general counsel” to refer to both internal and external lawyers who fulfill that role.
SECTION 2: JOINING A BOARD OF DIRECTORS
Joining a board and serving as a director can and should be a challenging, exciting, and rewarding experience. Board service entails significant responsibilities and requires a significant personal investment of time and attention. Directors must fulfill fiduciary duties of care and loyalty. Because directors put their reputations at stake, the decision whether to join a board should not be made casually.
An individual considering an invitation to join a board should carefully study the corporation, its business, its history, its board, and its senior management. The candidate should understand the reasons for the invitation and the board’s expectations. For example, would the candidate be expected to serve in a particular role on the board or any of its committees—perhaps as a member of the nominating and governance committee or as a designated “financial expert” on the audit committee?
The discussion in this Guidebook focuses on public company directors. Most directors of private corporations will likely have some ownership interest in or connection to the corporation, its founder, or its owners. If asked to join the board of a private company or a closely controlled company, an individual should explore the expected role of an outsider on the board and understand the corporation’s shareholder base (including any factions among the shareholders), its business, its reputation, and its legal profile. In addition, the candidate should understand the directors’ relationships with the shareholders; determine whether independent legal judgment is really desired and whether advice will be available if requested (and, if so, from whom); inquire whether an initial public offering of the corporation is contemplated; and consider taking some of the steps described in the following list, such as reviewing the corporation’s financial information and becoming familiar with its director and officer insurance coverage.
When asked to join the board of a public company, an individual should first assess the following:
whether the opportunity to serve on the board is sufficiently compelling to engage the individual’s serious interest and attention in light of competing commitments;
whether the individual has (i) sufficient time and flexibility to perform diligently the required duties for a director of that company, including if a corporate crisis or major transaction should arise; (ii) scheduling conflicts that would unduly interfere with the board’s normal meeting schedule; (iii) requisite skills and experience to participate meaningfully as a director of that company; and (iv) any present, foreseeable, or perceived conflicts of interest with the corporation, its business, or its senior management (e.g., material relationships with competitors, potential acquisition targets, potential acquirers, or close personal or business ties to the CEO, other directors, or other senior members of the management team);
whether the individual has or can develop a sufficient depth of understanding of the corporation’s business, business model, and competitive environment to be an effective director; and
whether the individual believes that senior management and the board have integrity and conduct themselves in an honest and ethical manner.
A candidate still interested in the opportunity and who believes that she or he has the ability to be an effective director and add value to the corporation should take the following steps:
meet with the nominating/corporate governance committee chair, board chair, lead director and/or other board representatives who extended the invitation, and with the CEO and other senior members of management, to discuss the corporation’s strategy, principal issues, board organization and procedures, and committee memberships contemplated for the individual;
assess the attitude of the CEO and senior management toward shareholder accountability and board activity to determine whether a proactive board and independent director judgment are truly desired;
review the corporation’s recent public disclosure documents, such as press releases, investor presentations, and SEC filings to learn about the corporation, including the nature of its business, its financial condition, risk factors, and stability of its current business activities and future prospects;
determine whether there are company- or industry-specific factors requiring special understanding or attention—for example, a financially challenged or distressed corporation may require specialized experience or an unusual time commitment, or a company facing serious competition or cyclic challenges may benefit from particular expertise; and
gather information about the corporation’s reputation in the investment community and in the business world generally, by reviewing press and analyst reports and conducting internet and other searches.
If, following preliminary diligence, the individual understands the corporation’s strategy, business activities, risks, culture, and prospects, and has a continuing and serious interest in the directorship opportunity, she or he should take these additional steps:
learn the structure and processes the board uses to provide effective oversight, including (i) the corporation’s corporate governance principles or guidelines and committee charters; (ii) the routine operation of the board and its committees, including its access to and interface with the CEO, CFO, and other senior management officers; (iii) the methods employed for monitoring and evaluating board and committee performance; (iv) the tone and culture of executive sessions of independent directors; (v) the “tone at the top” for integrity and diligence; and (vi) the procedures for appointments, evaluation, and succession planning related to senior executive officers, including the CEO;
review the audit committee’s membership and procedures and meet with the audit committee chair to discuss any recent or current critical financial or accounting issues (including rating agency concerns, if any), the clarity and transparency of public disclosures respecting the corporation’s financial affairs, and the effectiveness of the corporation’s programs to address risk management and legal compliance issues;
review recent examples of the “meeting book” provided to directors in advance of meetings and other information regularly provided to the directors;
identify the corporation’s regular internal and external legal and financial advisors and learn their role and participation in and availability to the corporation’s and the board’s activities;
understand, based on appropriate professional advice, the corporation’s director exculpation, indemnification, and litigation expense advancement provisions (in organizational documents and contracts) and the amount and scope of coverage provided by the corporation’s directors’ and officers’ liability insurance, the quality of the corporation’s insurance carrier(s), and whether the corporation has provided the outside directors with separate insurance;
request a briefing on significant claims or litigation against the corporation, especially any that involve the activities of the board of directors or involve any entity with which the prospective director is already affiliated; and
understand director compensation arrangements and determine whether they are commensurate with the effort required and the risk undertaken.
The corporation may require a confidentiality commitment from the candidate covering the disclosure of any non-public information regarding the corporation’s business and affairs. The corporation typically reimburses reasonable out-of-pocket expenses, such as travel expenses, incurred in the due diligence process.
When serving on a board, directors often value most the opportunity to collaborate on tough issues with other experienced business people who bring a wide variety of approaches, styles, and experience to boardroom deliberations. Directors must be able to work toward building consensus on issues. To facilitate this collaboration and decision-making process, directors must be able to formulate and articulate their views and engage in constructive dialogue in an atmosphere of candor, mutual respect, and confidentiality. Accordingly, in addition to the diligence steps outlined above, a candidate should attempt to assess the board’s collegiality and culture of constructive skepticism, to the extent feasible from an outsider’s perspective.
SECTION 3: RESPONSIBILITIES, RIGHTS, AND DUTIES OF A CORPORATE DIRECTOR
Directors have a responsibility to act in the best interests of the corporation and its shareholders. To do so, they must focus on maximizing the value of the corporation for the benefit of its shareholders. Directors fulfill this responsibility through two primary board functions: decision-making and oversight. The board’s decision-making function generally involves considering and, if warranted, approving corporate policy and strategic goals and taking specific actions such as evaluating and selecting top management, approving major expenditures and transactions, and acquiring and disposing of material assets. The board’s oversight function involves monitoring the corporation’s business and affairs including, for example, financial performance, management performance, compliance with legal obligations and corporate policies, and evaluating appropriate risk management structures. Both functions require that directors develop an understanding of the corporation’s business and the environment in which it operates, including the risks and opportunities it faces, and management’s capacity to run the business while managing risks. In addition, directors need to ensure that they have sufficient information to engage in informed decision-making and oversight.
Although the board is responsible for managing and overseeing corporate affairs, it typically delegates responsibility for day-to-day operations to a team of professional managers. Management has responsibility for such tasks. Directors must oversee the corporation’s activities effectively and make informed decisions without usurping the role of management.
Directors have, individually and collectively, various responsibilities and rights, described more fully in the next section. Directors should keep in mind that, aside from specific tasks that the board delegates to board committees, the board acts as a collective body. Further, even for delegated tasks, the board must continue to provide oversight. Directors must, however, exercise judgment on an individual basis, and informed judgment depends upon each director’s individual evaluation, preparation, and participation, as well as on group deliberation and interaction.
Federal laws and regulations, the listing standards of national securities markets, as well as judicial interpretations of state laws, have all increased the compliance and disclosure obligations for the board and management of public companies. These obligations do not, however, change the fundamental principles governing director action.
A. BOARD RESPONSIBILITIES
State corporate statutes define the relationship between the board and management of the corporation. In general, state laws provide that all corporate powers shall be exercised by or under the authority of the corporation’s board of directors, and its business and affairs shall be managed by or under the direction of, and subject to the oversight of, the board. Thus, typically, the board delegates management to officers and is then responsible for overseeing the corporation while management conducts the corporation’s daily affairs.
State corporate statutes emphasize the board’s responsibility to make major decisions on behalf of the corporation and to oversee the management of the corporation. Although these statutes do not specifically define board responsibilities, the following tasks are generally undertaken by the board and its committees:
monitoring the corporation’s performance in light of its operating, financial, and other significant corporate plans, strategies, and objectives, and approving major changes in plans and strategies;
selecting the CEO, setting goals for the CEO and other senior executives, reviewing their performance, evaluating and establishing their compensation, and making changes when appropriate;
developing, approving, and implementing succession plans for the CEO and top senior executives;
understanding the corporation’s risk profile and reviewing and overseeing the corporation’s management of risks;
understanding the corporation’s financial statements and other financial disclosures and monitoring the adequacy of its financial and other internal controls, as well as its disclosure controls and procedures;
evaluating and approving major transactions such as mergers, acquisitions, significant expenditures, and the disposition of major assets; and • establishing and monitoring effective systems for receiving and reporting information about the corporation’s compliance with its legal and ethical obligations.
As the foregoing reveals, the board’s principal responsibilities are to select the top management for the corporation, plan for succession, and provide general direction and guidance with respect to the corporation’s strategy and management’s conduct of the business. In so doing, the board should give significant consideration to the corporation’s financial and business objectives, as well as its risk profile.
In recent years, the average tenure of a CEO has fallen, making succession planning important, both for unexpected emergencies and with the long term in mind. Boards must develop, approve, and implement succession plans for the CEO and top senior executives. Some corporations establish separate succession planning committees, and in others, succession planning is a matter for the compensation or nominating committee or the full board. There is no “one size fits all” model for succession planning, but the board should take an active role in assessing on an ongoing basis whether the current senior management team is appropriate for the needs of the organization, as well as in implementing and periodically reviewing management development and succession plans. Through this process, boards gain the knowledge required to develop judgment about the corporation’s potential future leaders.
The board safeguards the corporation’s integrity and reputation. The CEO and senior management must take the leadership role to promote integrity, honesty, and ethical conduct throughout the organization. The board’s role is to assess the CEO’s commitment and efforts in this area, support and encourage appropriate values (including through policies and incentives), and provide oversight of the programs and procedures that management implements to support behaviors and identify issues that may arise (including reporting mechanisms). This board role includes directing the CEO and other members of the senior management team to establish the proper “tone at the top” by setting clear expectations for the corporation’s ethical behavior and conduct of its business in compliance with law.
A number of state corporation statutes expressly allow the board to consider the interests of employees, suppliers, and customers, as well as the communities in which the corporation operates and the environment. Of course, the board remains accountable primarily to shareholders for the performance of the corporation. Thus, non-shareholder constituency considerations are best understood not as independent corporate objectives but as factors to be considered in pursuing the best interests of the corporation. Indeed, being responsive to stakeholder interests and concerns can contribute positively to corporate valuation, its workplace culture, and reputation for integrity and ethical behavior.
Increasingly, boards—and, as directed, board committees—engage in periodic communications with shareholders. Board efforts to enhance shareholder communication and dialogue require sensitivity to director confidentiality requirements, as well as federal regulations on “selective” disclosure. In light of such obligations, individual directors should understand and abide by the board’s policies on confidentiality and selective disclosure and avoid responding to shareholder inquiries or communicating with any shareholders. Instead, shareholder communication and engagement should be undertaken on a coordinated and not an ad hoc basis.
B. INDIVIDUAL RESPONSIBILITIES
To be effective, a director must understand the corporation’s business, operations, and competitive environment. This knowledge is fundamental to the director’s ability to form an objective judgment about corporate and senior management performance and strategic direction, and to challenge, support, and reward management as warranted. Accordingly, a director’s understanding of the corporation and its industry should include:
the corporation’s business plan;
the key drivers underlying the corporation’s profitability and cash flow— how the corporation makes money both as a whole and also in its significant business segments;
the corporation’s operational and financial plans, strategies, and objectives and how they further the goal of enhancing shareholder value;
the corporation’s economic, financial, regulatory, and competitive risks, as well as risks to the corporation’s physical assets, intellectual property, personnel, and reputation;
the corporation’s financial condition and the results of its operations and those of its significant business segments for recent periods; and
the corporation’s performance compared with that of its competitors.
In addition, a director should be satisfied that effective systems exist for timely reporting to, and consideration by, the board or relevant board committees of the following:
corporate objectives and strategic plans;
current business and financial performance of the corporation and its significant business segments, as compared to board-approved objectives and plans;
material risk and liability contingencies, including industry risk, current and threatened litigation, and regulatory matters; and
systems of company controls designed to manage risk and to provide reasonable assurance of compliance with law and corporate policies.
Directors should do their homework so that they are prepared to participate actively. In addition to attending board and committee meetings, they should review board and committee agendas and related materials sufficiently in advance of meetings to enable them to participate actively in the deliberative process. Directors should expect to receive drafts of minutes of board and committee meetings in a reasonably prompt time frame, so that they can assure that minutes accurately reflect their recollections of what occurred at meetings and that identified active items are being pursued. Directors should also keep informed about the activities of board committees on which they do not serve.
More generally, directors should have an attitude of constructive skepticism. Directors should not be reticent or passive. To be a director means to direct—to participate on an informed basis, ask questions, challenge management as appropriate, apply considered business judgment to matters brought before the board, and when necessary, bring other matters to the full board’s attention.
Each director works for the benefit of the corporation—even if nominated or designated by a subset of the shareholder body (e.g., holders of preferred stock who may have special rights to elect a director), elected in a proxy contest, or appointed by the board to fill a vacancy. Directors may consider the interests of particular shareholders when performing their decision-making and oversight duties, but all directors must act in the best interests of the corporation and all of its shareholders.
C. RIGHTS
Because of important business decision and oversight responsibilities, all directors have both legal and customary rights of access to the information and resources needed to do the job. Among the most important are the rights:
to inspect books and records;
to request additional information reasonably necessary to exercise informed oversight and make careful decisions;
to inspect facilities as reasonably appropriate to gain an understanding of corporate operations;
to receive timely notice of all meetings in which a director is entitled to participate;
to receive copies of key documents and of all board and committee meeting minutes; and
to receive regular oral or written reports of the activities of all board committees.
In addition, within reasonable time and manner constraints, directors generally have the right of access to key executives and other employees of the corporation and to the corporation’s legal counsel and other advisors to obtain information relevant to the performance of their duties. Directors may (and should) request that any issue of concern be put on the board (or appropriate committee) agenda.
The right to information is accompanied by the duty to keep corporate information confidential and not to misuse information for personal benefit or for the benefit of others. For example, individual directors do not have the right to share confidential information with shareholders who nominate or elect them—unless they have express authority from the board (and subject to selective disclosure and insider trading prohibitions).
The board and its committees should expect the general counsel, if there is one, to be available as a resource to advise them. Correspondingly, the general counsel must recognize that the client is the corporation, as represented by the board of directors, and not the CEO or any other officer or group of managers. The board and board committees should have access to the corporation’s regular outside counsel, if one exists, and the authority to retain their own legal counsel and professional advisors, independent of those who usually advise the corporation. Indeed, the Sarbanes-Oxley Act and the Dodd-Frank Act both grant specific committees the right to engage counsel and advisors. The chapters on individual committees address these issues.
D. LEGAL OBLIGATIONS
The baseline legal standard for director conduct is that each director must discharge director duties in good faith and in a manner that the director reasonably believes to be in the best interests of the corporation. This standard encompasses a “duty of care” and a “duty of loyalty.” To satisfy the duty of care, a director must act with the care that a person in a like position would reasonably believe appropriate under similar circumstances. The duty of loyalty focuses on avoidance (or appropriate handling) of conflicts of interests, and requires fair dealing by directors involved in transactions that result or could result in personal or financial conflicts with the corporation. The duty of loyalty also requires directors to act in good faith. A lack of good faith would include (i) acting intentionally with a purpose other than that of advancing the best interests of the corporation, (ii) acting with the intent to violate applicable law, or (iii) failing to act in the face of a known duty to act in a manner that demonstrates conscious disregard of, or extreme inattention to, the director’s duties.
1. Duty of Care
A director’s duty of care primarily relates to the responsibility to become and remain reasonably informed in making decisions and overseeing the corporation’s business. As noted above, directors satisfy their duty of care when they act with the care that a person in a like position would reasonably believe appropriate under similar circumstances. This “reasonable belief” incorporates a director’s personal belief, but it also must be based upon a rational analysis of the situation as understandable to others. The phrase “like position” means that a director’s actions must incorporate the basic attributes of common sense, practical wisdom, and informed judgment generally associated with the position of corporate director. The phrase “under similar circumstances” recognizes that the nature and extent of the preparation for and deliberations leading up to decision-making, and the level of oversight, vary depending on the corporation’s circumstances and the nature of the decision to be made.
In particular, satisfying the duty of care requires that directors have all material information reasonably available. Directors generally meet this standard by attending meetings, reading materials and otherwise preparing in advance of meetings, asking questions of management or advisors, requesting legal or other expert advice when desirable for a board decision, and bringing the director’s own knowledge and experience to bear. To meet the duty of care, directors should consider the following:
a. Time commitment and regular attendance
Directors should commit the required time to prepare for, attend regularly, and participate in board and committee meetings. By state law, directors may not participate or vote by proxy; personal participation is required. Directors who are physically present at a meeting have the opportunity to engage in spontaneous interactions that occur before, during, and after the meeting, and are more aware of the group’s dynamics. Personal participation may also take place by telephone or other means of communication by which all directors can hear each other.
b. Need to be informed and prepared
Directors must take appropriate steps to be informed. Without sufficient information, directors cannot participate meaningfully or fulfill their duties effectively. In most cases, the best source of information about the corporation is management. Directors can ask management to be present at board or committee meetings. To be informed and prepared directors should:
ensure that management provides directors with sufficient information about the corporation’s business and affairs;
request additional information when appropriate; and
ask questions to ensure that they understand the information provided.
Directors should establish expectations with respect to management provision of sufficient information in a timely manner. If management is unresponsive or otherwise fails to satisfy such expectations, the board should consider taking action including, in appropriate circumstances, replacing management. When contemplating specific actions, directors should receive the relevant information far enough in advance of the board or committee meeting to be able to study and reflect on the issues. Important, time-sensitive materials that become available between meetings should be promptly distributed to directors. Directors should review carefully the materials supplied. If a director believes that information is insufficient or inaccurate, or is not made available in a timely manner, the director should request that action be delayed until appropriate information is available and can be studied. If expert advice would be needed for a decision, the director should request that the board seek such advice.
c. Right to rely on others
In discharging board or committee duties, directors may rely in good faith on reports, opinions, information, and statements (including financial statements and other financial data) from:
corporate officers or employees whom the director reasonably believes to be reliable and competent in the matters presented;
legal counsel, public accountants, or other persons as to matters that the director reasonably believes to be within their professional or expert competence or as to which the person otherwise merits confidence; and
committees of the board on which the director does not serve.
Such reliance is permissible unless the director has knowledge that would make the reliance unwarranted. Delegation to a committee does not relieve a director of oversight responsibility. Instead, a director should keep informed about committee and board activities.
Directors also implicitly rely on each other’s statements, good faith, and judgment in making decisions for the corporation’s benefit. Reliance is particularly likely when some directors have substantial experience or expertise in an area germane to the corporation’s business—for example, by having specialized knowledge about a particular industry. Directors are expected to use their knowledge, experience, and special expertise for the benefit of all directors and the corporation generally.
Obtaining input from competent advisors is a hallmark of a careful decision-making process. For this reason, directors who rely in good faith on advisors, professionals, and other persons with particular expertise or competence generally enjoy broad protections from liability. Nevertheless, reliance is appropriate only if directors reasonably believe that the advice is within the person’s area of competence and if they selected that person with reasonable care. Directors have the final responsibility for their actions.
d. Inquiry
Directors should inquire into potential problems or issues when alerted by circumstances or events suggesting that board attention is appropriate. For example, inquiry is warranted when information appears materially inaccurate or inadequate, when there is reason to question the competence, loyalty, or candor of management or of an advisor, or when common sense calls for it under the circumstances. When directors have information indicating that the corporation is or may be experiencing significant problems in a particular area of business or may be engaging in potentially unlawful or unethical conduct, they should promptly make further inquiry and follow up until they are reasonably satisfied that management is dealing with the situation appropriately. Even when there are no “red flags,” directors should satisfy themselves periodically that the corporation maintains information systems and procedures that are appropriately designed to identify and manage compliance and business risks and are reasonably effective in maintaining compliance with laws and corporate policies and procedures.
e. Candor among directors
Candid discussion among directors and between directors and management is critical to effective board decision-making. Generally, directors must inform other directors and management about information material to corporate decisions of which they are aware. Directors occasionally also have legal or other duties of confidentiality owed to another corporation or entity. In such a situation, a director should seek legal advice regarding the director’s obligations, including reporting confidentiality obligations to the other directors and not participating in consideration of the matter.
2. Duty of Loyalty
The duty of loyalty requires directors to act in good faith and in the best interests of the corporation—and not in their own interests or in the interests of another person (e.g., a family member or potential competitor) or organization with which they are associated. There are many situations in which loyalty to the corporation is an issue. These situations fall into two basic categories. The first involves situations where directors’ personal or financial interests conflict with the corporation’s, and the second involves disloyalty to the corporation for reasons other than personal or financial conflicts of interest.
a. Acting in good faith
The fundamental requirement of loyalty is that directors must act with the good faith belief that their actions are in the best interests of the corporation. Directors fail to act in good faith when they are disloyal either because their actions are motivated by bad faith or because they intentionally or knowingly disregarded their duties or responsibilities. Directors may fail to act in good faith in a variety of ways, including the following:
intentionally acting with a purpose other than advancing the corporation’s best interests;
failing to act when there is a known duty to act;
acting with the intent to violate, or with intentional disregard of, an applicable law;
failing to cause the corporation to establish internal controls, risk management, or monitoring and compliance systems; or
failing to respond to red flags.
b. Conflicts of interest
Directors should not use their position for personal profit or gain or for any other personal or non-corporate advantage. They should seek to avoid conflicts of interest and should take special care to disclose potential conflicts and handle appropriately any conflicts that may arise. Directors should be alert and sensitive to any interest they may have that might conflict with the best interests of the corporation, and they should disclose such interests to the designated board representative or committee and the general counsel.
When directors have a direct or indirect financial or personal interest in a matter before the board for decision—including a contract or transaction to which the corporation is to be a party, or which involves the use of corporate assets, or which may involve competition with the corporation—they are considered “interested” in the matter. Interested directors should disclose the interest to the board members who are to act on the matter and disclose the relevant facts concerning it. Directors should refrain from engaging in any transaction with the corporation unless directors who do not share the conflict (“disinterested directors”) or disinterested shareholders approve the transaction after full disclosure of the conflict or the underlying action is demonstrably fair (and can be proved so in court if challenged).
Sometimes a conflict arises from a corporation’s plan to do business with an entity with which a director has a preexisting relationship. Upon learning of such a conflict, the director should fully disclose the relationship and other pertinent information. If the confidentiality obligations a director owes to a third party impair or proscribe full disclosure, a director may not be able to discharge the duties to the corporation and may need to recuse himself or herself from all participation concerning the matter, or even to resign.
In most situations, after disclosing the interest, describing the relevant facts, and responding to any questions, the interested director should leave the meeting while the disinterested directors complete their deliberations. This enables the disinterested directors to discuss the matter without being (or creating the appearance of being) influenced by the presence of the interested director. A director should generally abstain from voting on matters in which she or he has a conflict of interest. Disclosures of conflicts of interest and the results of the disinterested directors’ consideration of the matter should be documented in minutes or reports. In some cases, a special committee of disinterested directors to review and pass on the transaction may be appropriate.
Conflicting interest transactions are sometimes unavoidable and are not inherently improper. Disinterested directors or shareholders, with full disclosure of material information about the transaction, may authorize these transactions. State corporation statutes usually provide specific procedures for authorizing or ratifying interested director transactions. Those procedures safeguard both the corporation and any interested director, and protect the enforceability of any action taken. Otherwise, if the transaction is challenged, the interested director must establish the entire fairness of the transaction to the corporation, judged according to circumstances at the time of the commitment.
A transaction between a director, or the director’s immediate family, and the corporation is a “related person” transaction under the federal securities laws and may require disclosure in the corporation’s annual report, proxy statement, or other public filings. Even if the transaction does not require public disclosure, the corporation may be required to disclose in general terms whether the board considered the transaction in determining whether the director is an “independent” director under market listing standards. In addition, corporations may have their own policies in these areas. Waiving such a policy for a director may trigger a disclosure obligation. Directors should be familiar with these disclosure requirements and related corporate policies. Disinterested directors should consider the ramifications of any disclosures when voting on a matter involving a director conflict.
c. Fairness to the corporation
Disinterested directors reviewing the fairness of a transaction involving conflict of interest or self-dealing elements should seek to determine (i) whether the terms of the proposed transaction are at least as favorable to the corporation and its shareholders as might be available from unrelated persons or entities; (ii) whether the proposed transaction is reasonably likely to further the corporation’s business activities; and (iii) whether the process by which the decision is approved or ratified is fair. If the transaction could adversely affect shareholders, the directors should be especially concerned that those shareholders receive fair treatment. This concern increases when one or more directors or a dominant shareholder or shareholder group has a divergent or conflicting interest.
d. Independent advice
Independent advice regarding the merits of a conflict of interest or related person transaction is generally helpful. This advice may be contained (i) in oral or written fairness opinions, appraisals, or valuations by investment bankers or appraisers; (ii) in legal advice or opinions on various issues; or (iii) in analyses, reports, or recommendations by other relevant experts.
e. Corporate opportunity
The duty of loyalty is also implicated when an opportunity related to the business of the corporation, including its subsidiaries and affiliates, becomes available to a director. Directors must typically make such opportunities available to the corporation before they may pursue them. Whether directors must first offer an opportunity to the corporation will depend on factors such as whether the opportunity is similar to the corporation’s existing or contemplated business, the circumstances under which the director learned of the opportunity, and whether the corporation has an interest or expectancy in the opportunity.
If a director has reason to believe that a contemplated transaction might be a corporate opportunity, the director should bring it to the attention of the board and disclose the material information that the director knows about the opportunity. If the board, acting through its disinterested directors, disclaims interest in the opportunity on behalf of the corporation, then the director is free to pursue it.
3. Business Judgment Rule
Judicial review of challenged decisions will normally be governed by the “business judgment rule.” The business judgment rule is not a description of a duty or a standard for determining whether a breach of duty has occurred. It is a standard of judicial review used to analyze director conduct to determine whether a board decision can be challenged or a director will be personally liable.
The business judgment rule presumes that in making a business decision, independent and disinterested directors acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation. The rule applies to suits by shareholders acting for themselves or derivatively on behalf of the corporation. The court will determine only whether the directors making the decision were independent and disinterested in the matter, informed themselves before taking the action, and acted in the good-faith belief that the decision was in the best interests of the corporation. If so, the court will not second-guess the decision and the directors will be protected from personal liability to the corporation and its shareholders—even if the board’s decision turns out to be unwise or the results of the decision are unsuccessful. Importantly, the business judgment rule protects only decisions whether to take or not to take action. It does not, however, protect the failure to take action or conduct implicating breaches of the duty of loyalty.
4. Duty of Disclosure
Directors should never mislead or misinform shareholders. In addition, directors have an obligation to furnish shareholders with all relevant material information when presenting shareholders with a voting or investment decision. Directors also have a duty to inform fellow directors and management about information known to the director that is relevant to corporate decisions.
5. Confidentiality
A director must keep confidential all matters involving the corporation that have not been disclosed to the public. Directors must be aware of the corporation’s confidentiality, insider trading, and disclosure policies and comply with them. Although a public company director may receive inquiries from major shareholders, media, analysts, or friends to comment on sensitive issues, individual directors should avoid responding to such inquiries, particularly when confidential or market-sensitive information is involved. Instead, they should refer requests for information to the CEO or other designated spokesperson.
A director who improperly discloses non-public information to persons outside the corporation can, for example, harm the corporation’s competitive position or damage investor relations and, if the information is material, incur personal liability as a tipper of inside information or cause the corporation to violate federal securities laws. Equally important, unauthorized director disclosure of non-public information can damage the bond of trust between and among directors and management, discourage candid discussions, and jeopardize boardroom effectiveness and director collaboration.
E. SALE TRANSACTIONS AND ELECTION CONTESTS
The board of directors establishes a corporation’s long-term business strategy and the time frame for achieving corporate goals. Directors may consider the relative merits of various alternatives for the corporation over the short, medium, or long term.
The sale of the corporation is one of the most important matters boards consider. An outright sale of the company for cash ends the shareholders’ ownership of the business. A sale of the corporation for stock changes the form and substance of the shareholders’ investment in the business. Directors should consider not only the potential value of the transaction to shareholders (compared with other alternatives reasonably available to the corporation over a reasonable time frame), but also the risks inherent in the transaction, including the risk that the transaction will not close. If the transaction is publicly announced but is delayed or not completed, the corporation risks losing valuable employees and disrupting relationships with key customers and suppliers. Although every sale transaction presents this risk, directors should consider the relative likelihood of events that might result in delay or failure to close, such as regulatory issues, as well as the possible mitigation of these risks.
Before deciding to sell the corporation, the directors must seek the best reasonably available price and terms and may need to put protective measures in place to help achieve their goals. There is no single blueprint a board should follow to obtain the best price and terms. In most cases, the board should engage experienced advisors familiar with customary terms, market conditions, and the legal and financial issues involved.
A potential sale of the corporation may present conflicts of interest for directors and officers who stand to benefit from change-of-control provisions or who have pre-existing relationships with one or more potential acquirers or will become part of the acquiring group. In this situation, the board can continue to act with the interested directors absenting themselves from the discussion. If an interested party is in a position to control the decision, a court may review the transaction to determine whether it is fair to the corporation and its disinterested shareholders. Where potential conflicts of interest are present, it is prudent to have independent and disinterested directors—who are empowered to engage independent, qualified advisors—handle negotiations with the interested party. The corporation will also have enhanced disclosure obligations under federal and state law in connection with a potential sale of the corporation, including any golden parachutes or compensation provisions with certain senior executive officers.
Similarly, as addressed in Section 10, directors generally have enhanced disclosure and legal obligations in connection with election contests. Because these situations have the potential to raise various strategic and financial issues, as well as complicated legal issues, directors should obtain advice from experienced counsel and qualified financial advisors.
F. FINANCIAL DISTRESS SITUATIONS
The directors of a corporation facing potential default on obligations or bankruptcy must make decisions not encountered by the directors of financially healthy companies. Although directors’ general responsibilities continue to apply, circumstances of severe financial distress can alter corporate goals and enhance creditors’ rights vis-à-vis the corporation. If a corporation is in financial distress, the corporation should consider decisions regarding dividends and other distributions, recapitalizations, reorganizations, and other major corporate actions only with the benefit of legal advice from experienced counsel.
Insolvency is a legally significant status of financial distress. A corporation may be considered insolvent where the fair value of the corporation’s liabilities exceeds the fair value of its assets. Insolvency also may exist if the corporation is not able to pay its debts as they fall due in the ordinary course of business. Directors should seek the advice of management if they are uncertain whether the corporation is solvent and, when appropriate, hire experienced counsel and other advisors to provide advice on the matter.
Insolvency generally gives rise to additional legal protections to creditors. The laws of most states and the U.S. Bankruptcy Code prohibit transactions that may prejudice creditors’ ability to obtain payment from the corporation. A corporation may be liable under these laws if it is in financial distress and transfers assets of value without receiving reasonably equivalent value in return. Similarly, various state laws and the U.S. Bankruptcy Code prohibit corporations from preferring some creditors over others. Directors who approve corporate action violating such laws, thereby resulting in harm to the corporation, in turn, may be subject to claims of personal liability for alleged breaches of legal duties.
The laws of many states also provide that directors of financially distressed corporations may be personally liable to the corporation or its creditors for causing the corporation to pay dividends or make other distributions to shareholders. Notably, the current or imminent insolvency of a corporation implicates the directors’ duties in a subtle but important manner. Rather than managing the corporation to advance shareholder interests, the directors of an insolvent corporation, and in some states, directors of a corporation in the “zone of insolvency,” must seek to maximize the value of the corporation so that the corporation can pay off as many of its legal obligations as possible. The reasoning behind this is straightforward: the corporation’s first duty is to meet its legal obligations. When a corporation cannot do that, shareholders’ interests become a secondary consideration.
SECTION 4: RISK MANAGEMENT, COMPLIANCE, AND OVERSIGHT
Risk management is a particularly salient issue for directors today and a significant part of the directors’ duty of oversight of the business and affairs of the corporation. Effective oversight of risk management requires directors to assess the corporation’s programs designed to address risks with respect to both strategic and compliance aspects. The board’s role is forward-looking, involving overseeing and assessing programs and ensuring that management is implementing programs that effectively manage risk.
Directors should understand and assess the risks confronting the corporation. The board, or an appropriate committee, should require management to provide and should receive periodic reports describing and assessing the corporation’s programs for identifying financial, industry, and other business risks and for managing such risks to protect corporate assets and reputation. In addition, the board must ensure that its risk management overview addresses not just legal and compliance issues, but also devotes time to strategy, product innovations, cyclical risks, and the like. Finally, a full understanding of the risk-management controls and infrastructure requires assessing all aspects, including the prevention, mitigation, and remediation of risks.
Boards should determine their corporations’ risk/reward appetite and risk tolerance in various business areas and oversee those risks effectively. Informed risktaking is key to achieving the right risk/reward balance. Corporations can and do pursue strategies involving risk—and most worthwhile entrepreneurial activity entails risk. As a result, the board’s responsibility with respect to risk is threefold. The board must understand the material risks facing the corporation, including competitive, product, and industry risks. It must also understand the corporation’s appetite for risk and ensure that appropriate systems and processes are in place to identify, monitor, and where appropriate, mitigate risk. Finally, it must consider, and sometimes manage, any risks related to governance and compensation that management is unable to manage due to inherent conflicts.
There is no “ideal” risk management program for all corporations. Instead, a board must ensure the corporation’s programs address the risks facing their companies in an appropriate manner. The range of risk-management programs is quite broad. Risk-management programs may address product liability, quality assurance, information technology security, insurance, legal compliance, plant security, confidentiality, intellectual property, and crisis management. Boards must address core business risks, strategic and competitive risks, and, for example, those associated with product development. Regardless of the industry or risk-management area, the board should have an understanding of the programs more generally, rather than being involved in the day-to-day risk management. To achieve this balance, some corporations designate a chief risk officer and/or create a high-level management committee on risk, either of which reports regularly to the board. Financial services corporations, however, often have board committees focused exclusively on risk. In any case, directors should ensure that they have appropriate information to identify, understand, monitor, and evaluate the material risks associated with the corporation and its activities.
Risks typically fall into three general categories: legal, operational, and reputational. Legal risks arise because corporations must comply with laws and regulations, which they sometimes fail to do. Operational risks arise from, for example, strategic failures, inadequate internal controls, corporate governance failures, human or technical error, product innovations or the lack thereof, financial issues, mergers and acquisitions, and external events, such as damage to physical assets from natural or other disasters. Reputational risks arise any time a risk, whether legal or operational, actually occurs. These areas, of course, are interrelated. For example, a failure of a corporation’s internal controls can result in a misstatement of revenues, leading in turn to a restatement, followed by litigation. Thus, an operational risk can lead to a legal risk and, then, to a reputational risk. The remainder of this section develops specific areas of risk management in more detail.
A. COMPLIANCE WITH LAW
The board is responsible for overseeing management’s activities in assuring the corporation’s compliance with legal requirements in the jurisdictions in which the corporation does business. A well-conceived and properly implemented compliance program can significantly reduce the incidence of violations of laws and corporate policy. It can also reduce or eliminate lawsuits, penalties, and criminal prosecution. Although the federal sentencing guidelines greatly increase the penalties for corporations guilty of criminal violations, they also provide for significant fine reductions for corporations with effective programs in place to prevent and detect such violations. Directors should periodically satisfy themselves that an appropriate process is in place to detect violations and to encourage not only attention to general legal compliance issues and claims against the corporation, but also the timely reporting of significant legal or other compliance matters to the board or an appropriate board committee.
Boards should ensure that their companies have formal written policies designed to promote compliance with law and corporate policy. They should review policies periodically for effectiveness, including evaluating the range, depth, and frequency of training and other programs for employees. Further, if the corporation operates in an industry subject to laws and regulations that demand special compliance procedures and monitoring, the review should be more frequent and intensive. Many public companies assign compliance oversight to the audit committee, others to a governance or risk committee. These committees meet regularly with the company’s appropriate business operations leaders and general counsel or outside counsel to be briefed on compliance and claims. With the increased burdens placed on public company audit committees, some boards have elected to form a separate compliance or legal affairs committee. Directors should consider whether delegating oversight for multiple compliance issues to a single board committee is sufficient for the corporation’s legal and regulatory compliance profile.
The board should ensure that employees of the corporation are informed and periodically reminded of corporate policies, including those pertaining to compliance with (i) codes of business conduct and ethics; (ii) anti-discrimination and employment laws; (iii) environmental and health and safety laws; (iv) anti-bribery laws; (v) antitrust and competition laws; (vi) securities laws, particularly those addressing insider trading; and (vii) laws and regulations of other countries as applicable. The major securities markets require their listed companies to adopt codes of business conduct and ethics applicable to all employees, officers, and directors. The corporation should have appropriate controls throughout the organization for monitoring compliance with such laws and codes. Controls may include whistleblower and hotline policies. The corporation also must establish procedures for addressing violations.
In addition, all compliance personnel should have direct access to the general counsel or other compliance officer to ensure sensitive compliance situations are promptly addressed. In addition, direct reporting access to the board or a board committee can result in “credit” under the U.S. federal sentencing guidelines. Boards should also ensure the compliance program has adequate resources and authority to perform its function.
B. COMPANY DISCLOSURES
The board bears ultimate responsibility for the quality and integrity of company disclosures. Disclosure documents (e.g., annual reports, quarterly reports, current reports, proxy statements, prospectuses, and earnings releases) must fairly present material information about the corporation and its business, financial condition, results, prospects, and risks. Management is responsible for drafting and preparing the corporation’s disclosures. Many public companies establish management disclosure committees with responsibility for the company’s SEC filings and other public financial disclosures. In other companies, the audit committee handles all financial disclosures. The board should, however, be satisfied that the corporation’s procedures for identifying matters requiring disclosure and preparing disclosure documents are reasonably designed to produce accurate and complete public disclosures in an appropriate and timely manner. In addition to the documents requiring their signatures, directors should be familiar with the corporation’s significant filings and be satisfied that disclosures convey all material information about the business in a proper and timely manner.
C. POLITICAL ACTIVITY
Corporate officers and employees frequently participate in the governmental process on behalf of the corporation by seeking to influence legislative activities, shape regulations, or encourage or prevent government action. Corporations can support or oppose election candidates and engage in political spending. Such actions are often highly visible and can affect the reputation of the corporation and attract shareholder attention. Accordingly, the board should monitor such activities and ensure that they are in accord with regulatory requirements, relevant company policies, and the company’s risk profile.
D. CRISIS MANAGEMENT
Finally, boards should periodically review whether the corporation has an appropriate crisis management plan in place. It may be appropriate to develop different kinds of crisis management programs and teams to respond to different types of potential emergencies. Board-level monitoring of such programs provides an objective review of management’s plans for response, lends credibility to the response, and assures board members are appropriately informed. Such programs include those for natural disasters, significant adverse corporate developments, civil unrest, or terrorist activities. Good crisis management programs address such needs as dissemination of information internally and to the public, provision of back-up systems and records, and adherence to employee safety and business operation procedures during the emergency. A good crisis management plan will also address CEO succession. (See Section 9.F for a more detailed discussion of succession issues.) Members of a crisis management team typically include outside counsel and other advisors.
E. EXECUTIVE COMPENSATION
Compensation can present significant risk management issues and is addressed in Section 8.
F. OTHER RISKS
Boards also oversee other corporate risks. Financial risks can occur in many contexts and require oversight. Asset impairment and acquisition integration situations also present risks for which the board should provide oversight. In addition, employee safety, health, and environmental protection, product safety, and human rights are not only matters of legal compliance; they are matters of legitimate public concern with important implications for the long-term success of the corporation. These issues increasingly drive consumer behavior, business partner decisions, employee morale, and business reputation. Compliance with environmental and human rights standards, whether government-mandated or self-imposed, is particularly important. Violations can present public safety and reputation concerns, have a material financial effect, and trigger state or federal civil or criminal investigations and liability. For example, global climate change concerns and the advantages of being a “green company” may affect business reputation, culture, morale, and financial performance. The board should periodically engage senior management in discussions of the risks associated with these areas.
SECTION 5: BOARD STRUCTURE, PROCESS, AND OPERATIONS
Board structure, process, and operations significantly affect the board’s ability to exercise its powers and discharge its obligations effectively. Properly functioning structures, processes, and operations encourage and reinforce the board’s ability to direct the corporation’s business and affairs on an informed and objective basis. No model fits every corporation. Instead, each board needs to tailor its approach to the unique needs and circumstances of the company. Primary tasks include selecting the chief executive officer, monitoring the performance of the CEO and his or her team, and providing management with advice and counsel.
Boards face a significant challenge in governing effectively given the part-time nature of board service. Most directors have competing demands on their time and attention, and most boards meet on average less often than once a month. Compounding this fact is that the board is comprised of a majority of independent directors who, by definition, have very limited relationships with the corporation outside of their board service. As a result, in addition to time constraints, independent directors have limited information sources about the company other than what management provides. Yet they must form objective viewpoints about the issues facing the company and the quality of the management team to perform fiduciary and other obligations. Careful attention to board structure, processes, and operations helps to overcome time limitations and information asymmetry and otherwise assists the board in establishing a culture and capacity for candor, objectivity, and efficiency.
A. BOARD COMPOSITION
1. Board Size
Each board should determine the appropriate size to accommodate the corporation’s needs, objectives, and circumstances. Factors that influence board size include the corporation’s need for particular types of expertise on the board, the ability to meet applicable independence or other regulatory standards, the need to populate committees with appropriate expertise as required by regulatory or other board-determined standards, and the need for relationships with significant shareholders or other constituencies. Boards should balance these needs with the fact that a board that is too large can impede effectiveness.
Board size varies substantially among public corporations, with some corporations, like those in the financial services industry, typically having larger boards. Except perhaps for the very largest and most complex corporations, smaller boards (seven to eleven members) generally function more effectively than larger ones, because directors have greater opportunities to participate actively in board deliberations and otherwise contribute. Individuals serving on larger boards may feel that their active engagement is less critical to the functioning of the group. Larger boards can overcome this perception and encourage individual director participation by relying more heavily on board committees in which individual directors actively participate.
2. Qualifications
The board has significant impact on board composition through its powers to nominate and re-nominate directors for election and to fill board vacancies between shareholder meetings. Boards should be prepared to explain why each director is appropriate to the overall board composition and should revisit the “fit” of each director on an annual basis. Boards should make these decisions with an understanding of the company’s strategic direction and the board’s needs. Indeed, boards should identify the personal qualities required of individual directors (such as integrity, candor, capacity for objective judgment) and identify the overall mix of expertise, experience, independence, and diversity of backgrounds it seeks. The board is more than the sum of its parts, and no one director will have all of the qualifications that the board seeks. The goal is to create a body with the right mix of skill sets, experiences, and diverse viewpoints to contribute to corporate success. The individuals should understand their fiduciary obligations to the company and its shareholders and be capable of expressing objective viewpoints, debating issues, exploring and resolving disagreements, and then—in most instances—forming and supporting a consensus view.
3. Time Commitment
Directors must devote substantial time and attention to their responsibilities, and the time required will vary considerably (depending on the size and complexity of the enterprise and the issues being addressed at a particular time). It is not uncommon for a director’s total time commitment to involve 250 hours or more a year, including meeting preparation, travel, meeting attendance, informal consultation with other board members and management, and review of materials to keep up with corporate developments. In addition, directors of the audit and compensation committees have especially significant demands on their time. Certain situations, including change-of-control transactions, financial distress, compliance failures, financial restatements, and management succession crises, also require substantially more time.
Directors considering new or continued board service should consider carefully the time required to meet their responsibilities. Directors should not over-commit themselves, and the nominating/corporate governance committee should consider a board candidate’s ability to devote the necessary time before nominating or re-nominating the candidate. Many boards of public companies establish limits on the number of other boards on which directors may serve and also require that directors inform the board before accepting additional board service or other significant commitments.
B. BOARD OBJECTIVITY AND DIRECTOR INDEPENDENCE
Directors must form their own objective judgments about what actions are in the best interests of the company and its shareholders. This obligation extends to assessments of management performance and the strategies and transactions proposed by management. Being an effective guide and sounding board for management also requires objective judgment. Objectivity or “independence of mind” requires constructive skepticism concerning management proposals and reports and the ability and willingness to challenge management constructively and test management’s assumptions.
The major securities markets require listed companies (other than controlled companies) to have a majority of “independent” directors. They also require that key oversight committees—audit, compensation, and nominating/corporate governance or any committee to which these committees’ duties are delegated—be comprised solely of “independent” directors. In addition, audit committee members must meet the separate definition of audit committee independence set forth in the Sarbanes-Oxley Act, which is, in some respects, more stringent than the major securities markets’ definitions of director independence. The Dodd-Frank Act imposes similar heightened independence standards on compensation committee members.
Generally, the major securities markets provide that a director is independent only if the board makes an affirmative determination that the director is free of any material family, charitable, business, or professional relationship (other than stock ownership and the directorship) with the corporation or its management that is reasonably likely to affect objectivity. When making annual independence determinations, the board should consider all relevant facts and circumstances, and review the materiality of a director’s relationships from both the director’s standpoint and the standpoint of the individuals or organizations with which the director has an affiliation. Proxy statement requirements call for disclosure of the names of the independent directors, as well as the principles underlying the independence determination and any transactions, relationships, or arrangements that the board considered in the independence determination but were not otherwise disclosed.
The major securities markets identify certain relationships as inconsistent with a finding of independence:
service by the director as an officer or employee of the corporation or any of its affiliated enterprises (three year look-back);
receipt by the director of compensation from the company above a threshold amount other than director and committee fees and certain forms of deferred compensation for prior service (three year look-back);
current business or professional relationships of the director with the corporation or one of its affiliated enterprises above a threshold amount;
service by an executive officer of the corporation on the compensation committee of a corporation that currently employs the director as an executive officer (three year look-back);
service by the director as a partner in or an employee of the corporation’s external auditor (three year look-back applies to partners and employees who worked on the company’s audit); or
involvement by a director’s immediate family member in one of the foregoing relationships (subject to certain modifications).
Director independence under listing standards does not qualify a director as “disinterested” with respect to any particular board decision. In reviewing director actions in conflict of interest situations or in a special committee context, courts will evaluate the range of business, social, and personal relationships among the directors participating in the decision or transaction and the corporation and its senior managers or other relevant parties.
C. BOARD LEADERSHIP
In many U.S. public companies, the CEO of the corporation also serves as chair of the board. A growing number of public companies have chosen to separate the two functions with the chair position held by an independent director who provides leadership to the board, often serving as a liaison between the board and the CEO, and sometimes serving as a mentor to the CEO. Where the CEO or another non-independent director serves as board chair, the independent directors often formally designate an independent director to act as a presiding or lead director. The chair of the nominating/corporate governance committee or a senior director often acts in that capacity. No one size fits all. Thus, boards need to decide what works best for their company.
The presiding or lead director typically works with the CEO to prepare the board agenda and determine the types of information to be distributed to the board and its committees, presides at executive sessions of the non-management and independent directors, and serves as the board’s liaison to the CEO between meetings. The existence of a lead director should not inhibit the ability of individual directors to communicate directly with the CEO. The presiding or lead director may also meet with shareholders or shareholder groups and should promptly inform the full board of such communications. The New York Stock Exchange (NYSE) requires listed companies to identify publicly, by name or position, the director or directors who preside at meetings of non-management directors and to inform shareholders and other interested parties how to communicate with non-management directors. Boards of public companies must disclose their board leadership structure and the rationale for that structure and its relationship to risk oversight.
D. AGENDA, INFORMATION, AND ADVISORS
Directors should play an active role in setting the board’s agenda, ensuring the quality and timely provision of information and access to information, and establishing relationships with key managers and advisors, including, for example, internal auditors, the CFO, and internal and external counsel.
1. Agenda
The board’s agenda dictates the matters that come before the board and the focus of board attention. Traditionally, management played a significant role in determining the matters to be presented to and acted on by the board, due to its greater knowledge of the day-to-day operations of the company. For the board to be effective and objective, however, it must control its own agenda. Thus, the trend is toward increasing independent director involvement in determining the board agenda. If there is a non-executive chair of the board or a presiding or lead director, that director and the CEO will often collaborate on the agenda and plans for the meeting. All directors should have the opportunity and feel free to request that an item be included on the agenda. Further, the board should satisfy itself of the overall annual agenda of matters requiring recurring and focused attention, such as the achievement (as well as periodic reexamination and updating) of operational and financial plans, the evaluation of the CEO and other executive management performance, the evaluation of board and committee performance, and the adequacy and appropriateness of corporate systems and controls addressing legal compliance, risk management, corporate policy, financial controls, and financial reporting and other disclosures.
2. Information
The quality of the information available to directors significantly affects their effectiveness. Because management is the primary source of information about the corporation, directors should insist that management provide them with information that is (i) timely and relevant, (ii) concise and accurate, (iii) well organized, (iv) supported by any background or historical data necessary to place the information in context, and (v) designed to inform directors of material aspects of the corporation’s business, performance, and prospects. Directors should receive agenda-related information sufficiently in advance of board or committee meetings to allow careful study and thoughtful reflection and to accommodate requests for additional information.
Many boards also access or receive analysts’ reports about the corporation for outside perspective and analysis, as well as benchmarking data. This information allows boards to make comparisons to other corporations in the same industry group or with similar characteristics. Increasingly, directors communicate directly with senior-level employees and managers to learn more about the corporation’s business. Some boards schedule site visits for non-management directors so they can directly observe business operations and speak with employees at the operating level of the business.
3. Legal Advisors
Boards generally look to the corporation’s general counsel as the primary resource for legal analysis and governance advice. The general counsel’s client is the corporation, as represented by the board of directors, not the CEO or any other officer or group of managers. For this reason, many boards and key board committees meet regularly in a private session with the general counsel. In addition, the board and each of its committees should have access to the corporation’s regular outside counsel, if there is one, and should have the authority to retain legal counsel and professional advisors, independent of those who usually advise the corporation. Moreover, the Dodd-Frank Act will require compensation committees to consider conflict of interest factors before engaging legal advisors. A specific circumstance (e.g., allegations of management wrongdoing or negotiating executive pay packages) may prompt the board or, more likely, a board committee to seek independent advice. A board committee may also choose to have regular outside counsel advise the committee generally in meeting its duties and responsibilities.
As part of their annual self-evaluations, the board and each of its committees should consider whether each is receiving appropriate advice as to legal and compliance requirements and timely updates on legal exposure. In addition, each should consider whether it has a good understanding of when to seek legal advice from lawyers other than the general counsel and the outside lawyers regularly engaged by the corporation.
4. Non-legal Advisors
In addition to employees, officers, and legal advisors, boards often consult other outside advisors. The need for and degree of consultation varies across companies and industries. For example, boards involved in discussions about a merger or acquisition often engage investment bankers for advice. Although covered in more detail in Section 8, compensation consultants may provide information and expertise in the compensation-setting process. Boards of companies in industries with significant environmental, health, and safety issues may also choose to engage outside consultants to review, for example, environmental safety practices and procedures.
E. EXECUTIVE SESSIONS
The major securities markets require periodic meetings of non-management and independent directors in executive session (i.e., without management present) and many public companies hold an executive session every board meeting. These sessions provide a forum for non-management and independent directors to raise issues and ideas they may otherwise be reluctant to raise in the full boardroom, to share candid views about management’s performance, to discuss whether board operations are satisfactory, and to raise potentially sensitive issues regarding specific members of management. These sessions are usually coordinated with meetings of the board and, if regularly scheduled, become routine and accepted by management.
If the CEO is also the board chair, most boards designate a director to convene and preside at these sessions. This is a role for a presiding or lead director. Executive sessions may have agendas that are set in advance, but it is also common for the agenda to be open-ended, allowing non-management and independent directors to discuss anything that is on their minds related to the company and its management. Following each session, either the presiding director or the group typically briefs the CEO on what was discussed and on whether any actions are now required.
An executive session should occur during the course of a properly convened board meeting. Directors in an executive session cannot take formal action on behalf of the board when a quorum is not present or if one or more directors have been excluded from the session without consenting to action in their absence. For this reason, and to facilitate open and candid discussions regarding sensitive issues, detailed minutes of executive sessions are not typically kept. It is important, however, to maintain minutes covering attendance and the topics discussed, as well as any recommended actions.
Non-management and independent directors should feel free to meet in executive sessions whenever they feel called to do so and to consider management-sensitive issues, such as controversies involving senior management, change-of-control transactions, or major changes in management. Special advisors, such as special counsel, financial advisors, or others may be appropriate in such cases.
F. NUMBER OF MEETINGS AND SCHEDULING OF MEETINGS
The board should determine its meeting schedule based on an understanding of the tasks to be accomplished over the course of a year and should strive to develop a meeting schedule to optimize the board’s time accordingly. The number of meetings a board finds necessary or useful varies with the size, complexity, and culture of the enterprise. Some boards prefer more frequent, shorter meetings, whereas others prefer fewer, lengthier meetings. Some boards schedule one extended planning or strategic meeting each year and shorter meetings during the rest of the year. Boards should hold regularly scheduled meetings at least quarterly, but many schedule six to eight regular meetings a year and hold additional special meetings as needed.
Time at board and committee meetings requires careful scheduling because the length of time budgeted for a meeting limits the topics and depth of the discussion at that meeting. Moreover, meetings should balance management presentations with discussion among directors and with management. Appropriate reports and analyses furnished in advance facilitate discussion at the meeting.
G. MINUTES, NOTE TAKING, AND BOARD MATERIALS
All meetings of the board of directors and board committees—whether regular or special meetings or executive sessions—should be memorialized in minutes prepared promptly and circulated for comment and approval. The corporate secretary or another person skilled in preparing minutes should prepare the draft. When the board or committee approves the minutes, the corporation must retain them as a corporate record. Minutes are important legal documents. For example, auditors, courts, regulatory bodies, and shareholders may review them. Therefore, minutes require directors’ attention and care.
As appropriate, minutes should contain the following:
(i)
the place, date, and time of the meeting;
(ii)
the attendees (noting who attended in person or by conference call);
(iii)
the chair of the meeting;
(iv)
the topics discussed;
(v)
the matters voted on and the outcome (or a statement of decisions reached by consensus);
(vi)
the directors or other attendees, if any, who abstained from voting or were absent from certain discussions at the meeting;
(vii)
the material terms approved by the board or board committee;
(viii)
the materials (incorporated by reference) provided to the directors before and at the meeting;
(ix)
the people who provided information and advice at the meeting;
(x)
the facts surrounding any discussions held or information exchanged between or among some directors before the meeting relating to matters considered at the meeting;
(xi)
the secretary or acting secretary for the meeting; and
(xii)
the time of adjournment.
Although there are differing opinions among corporate advisors about the appropriate level of detail to be included, minutes should be sufficiently detailed to support the availability of the applicable protections provided by substantive law. Thus, minutes should summarize important discussions and actions, without generally purporting to provide a verbatim record or attributing specific words or points of view to particular directors. Minutes that do not reflect that an adequate deliberative process occurred can support an inference that directors failed to consider pertinent information fully and in good faith. Typically, the minutes should reflect appropriately the amount of time devoted to an issue, either by specifically stating the time or by writing the minutes so that the length of the minutes devoted to a particular issue corresponds to the actual time devoted to the issue. The key is to avoid an incorrect inference that less time was devoted to a subject than was in fact the case.
If named as defendants or called as witnesses in litigation, directors will need to explain their actions well after the fact. Detailed minutes provide a contemporaneous record of their deliberative process and can help prevent criticism about the adequacy of that process. Consequently, the minutes should reflect the reality that the directors engaged in a deliberative process, acted in what they reasonably believed to be the corporation’s best interests, and considered the possible alternatives.
Note taking implicates similar issues. Directors are not obligated to take notes. Those who do take notes to help them participate should consider whether to retain them. Notes are not subject to a careful process of drafting, review, and approval, and may contain statements or notations that may be misinterpreted, taken out of context, or in fact, be incorrect, particularly if produced in litigation. For example, notes often capture only part of a discussion or fail to distinguish between words spoken and the note taker’s thoughts. Similarly, notes and drafts of the secretary of the meeting should normally not be retained after approval of the official minutes.
Furthermore, directors should confirm that the corporation maintains files containing the information provided to the board, such as board books and Power-Point presentations. This information can help demonstrate the board’s informed business judgments and assist directors in recollecting past events. The corporation should develop, with board approval, a consistent policy for the retention of such information so that, together with quality minutes, there is a reliable record of the board’s deliberations.
Finally, the corporation’s counsel should monitor the consistency of the corporation’s approach to minutes and recordkeeping. With multiple committees and minute takers, inconsistencies in format and approval could arise and create issues in litigation or regulatory proceedings.
H. BOARD EVALUATIONS
The major securities markets require directors to evaluate, at least annually, the effectiveness of the board and each of its committees. Board and board committee self-evaluations are most effective when planned in advance, with participants having a clear idea of the purpose of the self-evaluation and the issues to be addressed. The typical goal is to consider ways in which the board and its committees can improve their processes. Many boards find director interviews to be a helpful basis for collecting input from individual directors for board and committee discussions. In addition, some boards use written questionnaires to gather information. Questions on these forms must be drafted and used with care. External facilitators may be helpful in collecting information and presenting it in a manner that assures confidential treatment of individual director views. Some boards also use facilitators to lead discussions, providing experience with other companies and an independent perspective. It may be useful to maintain in the minutes a record of the process followed and any specific decisions of the board or committee that resulted, but it is not necessary to retain written materials.
The nominating/corporate governance committee generally conducts or supervises individual director evaluations and is discussed separately in Section 9 of the Guidebook.
I. COMMUNICATIONS OUTSIDE THE BOARDROOM
Directors often have individual communications relating to the corporation with management or with other directors. One-on-one communications can efficiently tap a particular director’s expertise or point of view. Indeed, these communications are inevitable.
Excessive communications outside the board and committee rooms, however, particularly between management and a select group of directors, can lead to uneven knowledge among directors about important corporate issues. Such communications may also impair the collective, inclusive, and candid exchange of views at board or committee meetings and interfere with the board’s collegial and independent relationship with management. Moreover, because official action by directors can occur only at a duly called meeting or by unanimous written consent, individual “polling” of directors is not sufficient to authorize action requiring board approval. Instead, the full board or the appropriate committee should discuss issues fully and appropriately at board meetings.
J. DECISION-MAKING
Directors make decisions on a wide variety of matters, sometimes giving direction to management and at other times approving major transactions. Some matters—such as changes in charter documents, authorization of dividends, election of officers, approval of mergers, financings, or corporate liquidations— generally require board action (as well as shareholder action, in some cases) as a matter of law. Directors can take formal action only at duly held meetings of the board or board committee or by unanimous written consent. Unanimous written consents are advisable only for routine matters.
Before taking or approving major actions, directors should receive relevant information to support an informed decision, including summaries and supporting materials. Information is critical to the directors’ ability to assess the precise actions proposed. Directors should satisfy themselves with the level of detail they receive and the scope of the resolutions they approve.
Not all board or committee decisions are formalized by the adoption of resolutions. Some may simply result from a consensus or a “sense of the board” to provide guidance to management. Meeting minutes should adequately describe and memorialize these decisions, and, thereby, avoid any misunderstanding among directors and management.
Business constraints or a crisis can prompt important corporate decisions. A well-developed crisis plan and familiarity with the corporation can enhance decision-making in this context.
K. DISAGREEMENTS AND RESIGNATION
Boards of directors usually make decisions by consensus. Acting in the best interests of the corporation, however, does not require unanimous agreement at all times. If, after a thorough discussion, a director disagrees with any significant action the board is taking, the director should consider abstaining or voting against the proposal. The director should also consider requesting that the abstention or dissent be recorded in the meeting’s minutes. Except in unusual circumstances, taking such a position should not cause a director to consider resigning. Resignations should be considered if a director believes that management is not dealing with the directors, the shareholders, or the public in good faith or that the information being disclosed by the corporation is inadequate, incomplete, or incorrect and the director is unable to convince the board to take action. Directors may also consider resigning when they feel their point of view is being disregarded entirely. Public corporations are required to disclose director resignations in an SEC filing, and this disclosure, like others, should be done in consultation with legal advisors.
SECTION 6: COMMITTEES OF THE BOARD
Committees perform much of the work of the board of directors. No universal mandate exists for a particular committee structure, except for certain actions and duties. In particular, federal law and the major securities markets’ listing standards require the audit, compensation, and nominating/corporate governance committees to be composed of independent directors. The boards of some public companies function almost entirely at the board level and delegate to committees only to the extent required. At others, the board acts as a group only on the highest level strategy and policy matters and matters legally required to be addressed by the full board, with most board action and oversight delegated to committees. Each board should tailor its processes and committee structure to the company’s specific circumstances, including size, the complexity of its operations and risk management issues, the regulatory schemes applicable to its operations, and the competitive environment in which it operates.
Reliance on independent board committees to counterbalance potential conflicts of interest and provide unbiased perspective is intended to improve corporate governance and transparency. Independent directors have become increasingly important in the wake of corporate scandals and market instability. In addition, regulators may require or encourage boards of companies in heavily regulated industries to establish committees to address particular issues. Boards may also delegate to a committee matters that require specialized knowledge or experience or a significant additional time commitment. Unlike the standing committees to which specific responsibilities must be delegated by law or major securities market rules, other board committees may be either permanent committees or specialized committees, which can have a limited duration.
The allocation of specific responsibilities between the full board and its committees, as well as among different committees, varies from company to company. For example, some boards direct their audit committees to handle the primary review and oversight of risk management matters. Other boards assign risk oversight to a specific risk-management committee. Still others retain responsibility for oversight of risk management as a duty of the full board, but delegate certain specialized aspects to the audit, compensation, and governance committees. Some boards create committees devoted to safety or the environment.
Boards may also create special committees to respond to specific circumstances. For example, an allegation of management wrongdoing may prompt a board to form a special committee. Another board, however, might assign the investigation to its audit committee, particularly if the allegations relate to financial, accounting, or internal control issues. In either case, the committee may decide to engage an outside investigation team, particularly if management wrongdoing is implicated.
As this discussion makes clear, statements in this Guidebook that particular committees consider certain matters are generalizations. Each board must consider its circumstances and tailor its board structure and allocation of responsibilities accordingly (mindful, of course, of applicable SEC and major securities market listing requirements).
Directors serving on board committees are subject to the same duties of due care and loyalty and entitled to the same protections of the business judgment rule as they are when acting as members of the full board. Delegation of a given responsibility to a committee does not relieve the full board of ultimate responsibility for oversight of the company. As in other areas of delegation, however, directors may rely upon the efforts of those to whom they delegate if it is reasonable to do so. In accord with their obligation to provide oversight, however, boards should ensure that committees establish appropriate procedures, including keeping minutes and records and providing a regular flow of reports and information to the board to ensure that all directors are kept abreast of each committee’s activities and significant decisions.
A. STANDING COMMITTEES
Some committees are intended to remain in place indefinitely, such as the audit committee, discussed in detail in Section 7, the compensation committee, discussed in detail in Section 8, and the nominating and corporate governance committee, discussed in detail in Section 9. A board may also decide to establish standing committees to oversee ongoing matters, such as risk management or management of complex regulatory schemes. A key factor to consider in creating a standing committee is whether it is more efficient and effective for a smaller group of directors to develop a detailed understanding of the relevant topic and use that expertise to review and monitor the issues within the committee’s purview.
Historically, many public company boards appointed standing “executive committees” comprised of directors who were usually officers or who were otherwise available to meet on short notice to address matters between regular meetings of the board. With advances in modern telecommunications, extensive use of executive committees has waned. Indeed, they are often perceived as subordinating the roles of other directors.
B. SPECIAL AND OTHER COMMITTEES
From time to time, a board may need to create a committee to undertake a specific project or responsibility. In such instances, defining the scope of delegated authority and responsibility of the committee is important. The board should consider and set down in a detailed resolution or committee charter the committee’s authority and responsibility. For example, a board may decide to form a special committee of disinterested directors to consider transactions involving conflicts of interest between the corporation and its officers. The members of an ad hoc committee need not necessarily meet applicable legal or securities market independence definitions. They should, however, be disinterested in the subject matter and otherwise able to exercise independent judgment. The committee should also establish thorough procedures for its deliberations. A properly constituted and operating special committee will help to reduce the risk of a successful challenge to the board’s actions and the potential for director liability.
Public company boards may also form an ad hoc committee of independent, disinterested directors to conduct investigations involving potential litigation or wrongdoing. In these cases, the board usually authorizes the committee to engage independent legal counsel and other advisors to help the committee investigate the facts and determine appropriate responses. In each case, the exact scope of authority and functions of the committee will depend upon the unique circumstances of the committee’s charge, including the credibility of the allegations, the nature of the alleged wrongdoing, and the familiarity of the committee members with the issues. Depending on the scope of authority delegated to the committee, the committee should complete the investigation and then take appropriate action on behalf of the board or recommend an appropriate course of action to the full board of directors.
If allowed under state law, a board may occasionally feel compelled to create a single-person committee. For example, a board may need to react quickly to market conditions and delegate to a one-member committee the authority to price a securities offering. Although single-person committees can be effective in limited contexts, they are not ideal. Multiple directors provide different perspectives on complex issues.
C. COMMITTEE PROCEDURES AND ACTIVITIES
Committee composition, procedures, and activities vary from corporation to corporation. The following bullets provide some general guidelines for each area.
Committee establishment—The board should give due consideration to defining the scope of the committee’s responsibilities and authority, including:
defining the specific issues the committee should address;
determining the committee’s scope of authority (e.g., is the committee empowered to act on behalf of the board or is the committee to recommend action to the board);
ensuring appropriate independence, including the authority to engage independent legal counsel and other advisors at the company’s expense;
establishing standards for committee operations, including frequency and scheduling of meetings, for example to avoid scheduling conflicts with full board or other committee meetings;
ensuring regular reporting to the board;
determining whether a committee should be a standing committee or a special committee; and
detailing the committee’s responsibilities and authority in a written board resolution or in a separate charter approved by the board.
Committee composition—The board should select committee members using criteria appropriate to the committee’s purpose and in compliance with any applicable legal and stock exchange requirements. Under most state statutes each member of a board committee must be a duly elected or appointed member of the board of directors. Committee membership criteria may include:
experience relevant to committee responsibilities;
subject matter expertise that will assist the committee in its work;
committee members’ ability to meet requisite time commitments;
disinterest in the committee’s subject matter; and
independence from management, as appropriate.
Reporting to the board—Board committees should regularly inform the board of their activities. Generally, standing committees should provide reports at regularly scheduled full board meetings and circulate to all directors committee agendas, minutes, and written reports, subject to considerations such as the need to protect sensitive information, contractual confidentiality requirements, privacy rights, and governmental security clearance requirements.
Legal limits of authority—Boards and committees must take care to observe applicable limits on their authority. For example, most state corporation statutes require that the board, rather than a committee of the board, approve proposed amendments to the company’s articles or certificate of incorporation and similarly require that bylaws (other than those adopted by shareholders) be adopted by the board, rather than by a committee of the board.
Scope of delegation and responsibility—The scope of responsibility of each committee should be tailored to the matters to be addressed. The authority, function, and responsibilities of each committee should be clearly defined. In the past, this was typically done in bylaws or board resolutions. Today, federal statutes and regulations and stock exchange rules require specific duties, responsibilities, and powers to be assigned to specific committees, such as the audit and compensation committees. In addition, the scope of authority and the duties of committees responsible for audit, compensation, and nominating/corporate governance matters must be specified in written charters.
Periodic review by the board—The board or an appropriate committee, such as the nominating and corporate governance committee, should periodically review the responsibilities assigned to each committee and consider whether the assignments of duties and responsibilities continue to be appropriate and consistent with the company’s needs and objectives.
SECTION 7: AUDIT COMMITTEE
The audit committee is critical to the corporate governance structure, and its existence and some of its functions are legally mandated. It has general oversight responsibility for the company’s financial reporting process and internal controls. It also has the exclusive responsibility for retaining and overseeing the performance and independence of the corporation’s external auditor. When the external auditor audits the company’s internal controls over financial reporting under Section 404 of the Sarbanes-Oxley Act, it will evaluate the committee’s performance. The audit committee also increasingly serves as a forum in which the internal and external auditors, as well as the corporation’s legal counsel and its compliance and ethics personnel, can candidly report and discuss issues relating to accounting, auditing, financial reporting, risk management, legal, compliance, and ethical matters.
A. MEMBERSHIP
Public company audit committees must consist solely of directors who satisfy the independence requirements of both the company’s securities market’s listing standards and the federal securities laws. Generally, audit committee members may not receive any compensation from the corporation, such as consulting, advisory, or similar fees, other than their director and board committee fees.
The major securities markets require that the audit committee have at least three members. Typically audit committees consist of three to five independent directors. The major securities markets also require that all committee members be financially literate, and at least one audit committee member must have accounting or financial management experience.
In addition, under the Sarbanes-Oxley Act, a public company must disclose in its annual report to the SEC or in its annual meeting proxy statement whether any member of its audit committee qualifies as an “audit committee financial expert,” a term defined by SEC regulation and focused on accounting and auditing knowledge and experience. If the committee does not have such an expert, the corporation must disclose why. If the board determines that a committee member qualifies as a “financial expert,” the corporation must disclose the name of that member and state whether that expert is independent. Because of this disclosure requirement, most public companies seek to have at least one member of the audit committee qualify as an audit committee financial expert. The requirements for that designation are quite stringent. Thus, directors to be designated as audit committee financial experts should be personally satisfied that they meet those requirements.
Common sense, diligence, and an attitude of constructive skepticism are critical qualifications for an audit committee member. Audit committee members should also have a sufficient understanding of financial reporting and internal control principles to provide oversight for both. New audit committee members should become familiar with key financial issues and accounting practices in the industry or industries in which their corporation operates. All committee members should be current in their knowledge of these financial issues and accounting practices. Continuing education and professional advice, either offered by the corporation or by third party service providers, can be helpful for ensuring members are up to date on best practices and developments.
B. PRINCIPAL FUNCTIONS
Federal law, SEC regulations, and securities market listing standards establish many of the audit committee’s duties and responsibilities. Audit committees assume other functions as a matter of good practice. Current regulatory requirements for public companies mandate a formal, written charter for the audit committee, specifying the duties and responsibilities. The committee must review the charter annually and publish it on the company’s website, or disclose the availability to shareholders, at least once every three years in the corporation’s proxy statement.
Audit committee members should understand the tasks in the charter and develop a schedule for performing the tasks. Audit committees generally rely on the corporation’s accounting, finance, treasury, internal audit, and legal staffs, as well as the corporation’s external auditor, for information. The committee also has the authority to employ its own accountants, attorneys, or other advisors, and the Sarbanes-Oxley Act requires the corporation to pay for these advisors. In light of their significant responsibilities, audit committees of public companies often consult with legal counsel to ensure they meet their responsibilities. Identifying the types of information they should receive and review, developing operational procedures and a schedule of tasks, and fulfilling disclosure, accounting, and internal control obligations, are key to audit committee effectiveness. Effective members, of course, also engage in “constructive skepticism.”
The following list sets forth the duties for public company audit committees as required by SEC rules and securities markets listing standards. Listing standards vary, so committees should check specific standards.
Audit committees of listed companies are required to:
select and engage the corporation’s external auditor, evaluate the auditor’s independence, qualifications, and performance, and determine, for each fiscal year, whether to continue that relationship;
review and approve annually the external auditor’s fee arrangements and the proposed terms of its engagement, including the scope and plan of the audit;
approve, before each engagement, any additional audit-related or non-audit services to be provided by the audit firm, based on the committee’s judgment as to whether the firm is an appropriate choice to provide such additional services and whether the engagement might impair the firm’s independence;
establish procedures to receive and respond to any complaints or concerns regarding the corporation’s accounting, internal controls, or auditing matters, including procedures for the confidential and anonymous submis-sion by employees of any such complaints or concerns;
serve as a channel of communication between the external auditor and the board and between the head of internal audit, if any, and the board;
discuss the corporation’s quarterly and annual earnings press releases and financial information and earnings guidance to analysts, the financial press, and rating agencies;
review the corporation’s annual and quarterly financial statements and management certifications, with both management and the external auditor, and discuss with each of them any major issues regarding accounting principles and financial statement presentation and the quality of management’s accounting judgments in preparing the financial statements;
provide oversight of the internal audit function (NYSE-listed companies);
review the Management’s Discussion and Analysis section in each periodic report before filing it with the SEC, and discuss with management and the external auditor any questions or issues that arise in connection with that review;
review the effect of regulatory and accounting initiatives, as well as offbalance sheet structures, on the financial statements;
oversee the company’s compliance with legal and regulatory requirements;
set clear hiring policies for employees or former employees of the independent auditors;
discuss polices with respect to risk assessment and risk management;
determine whether to recommend to the board that the audited annual financial statements be included in the corporation’s annual report on SEC Form 10-K;
review and approve the audit committee’s annual report to shareholders required to be included in a public company’s annual meeting proxy statement;
receive and consider required communications from the external auditor as a result of its timely review of the quarterly financial statements;
consider, in consultation with the external auditor and the senior internal auditing executive, if any, the adequacy and effectiveness of the corporation’s internal controls, which, among other things, must be designed to provide reasonable assurance that the corporation’s books and records are accurate, that its assets are safeguarded, and that the publicly reported financial statements prepared by management are presented fairly and in conformity with generally accepted accounting principles;
review with the external auditor any audit problems or difficulties, and management’s response;
review management’s annual assessment of the effectiveness of the corporation’s internal controls over financial reporting and the external auditor’s audit of internal controls over financial reporting;
report regularly to the board of directors; and
conduct an annual self-evaluation.
Other duties and responsibilities that many audit committees undertake as matters of good corporate practice include:
approve (in coordination with the corporation’s nominating or governance committee) any related person transactions between the corporation and its officers or directors, or their family members or enterprises they control;
establish a direct or “dotted-line” reporting relationship between the internal auditor and the audit committee, with appropriate input in the hiring, compensation, performance review, and the reassignment or firing of the head of internal audit, as well as approving internal audit plans and the budget for the internal audit group;
consider the appropriate reporting relationship between the chief compliance officer (if other than the chief legal officer) and the audit committee;
review SEC staff comments on filings;
review the external auditor’s management letter and management’s responses to that letter (which generally includes comments on any control deficiencies observed during the audit and other recommendations arising from the audit);
review primary components of earnings releases prior to public disclosure;
meet periodically with representatives of the corporation’s disclosure committee, if any; and
if another committee does not do so, meet privately with the corporation’s legal counsel or other key advisors to review pending litigation, possible loss contingencies, and other legal concerns, including procedures and policies for addressing legal and compliance issues and reduction of legal risk. (For public companies, this is generally done quarterly in connection with the review of the corporation’s Form 10-Q.)
C. ENGAGING THE AUDITORS AND PRE–APPROVING THEIR SERVICES
One of the key roles of the audit committee is engaging and supervising the company’s external auditor. The audit committee reviews and approves the terms of engagement and should know about and understand the scope of the audit. The audit committee must pre-approve all audit and non-audit services the external auditor performs during the year, as well as any audit-related services performed by any other auditing firm. The pre-approval process ensures that the audit committee will consider the effect of any audit and non-audit work on the auditor’s independence. In addition, the external auditor must provide an annual letter about its independence to the audit committee of a public company. The committee must discuss this letter with its auditor and consider what effect, if any, non-audit services that the external auditor provides will have on the auditor’s independence.
Many audit committees develop policies and procedures to pre-approve specific and detailed types of audit and non-audit services before the need for an engagement arises. Notably, the audit committee must pre-approve all tax services and internal control-related services, engagement by engagement. Some committees delegate this pre-approval authority to the chair (or a subcommittee) of the audit committee to assure that necessary services proceed efficiently, even between audit committee meetings. Any individual or entity that has this authority must report all decisions to the full committee. The audit committee also reviews the hiring of any former personnel of the auditor to assure that it meets regulatory restrictions and will not affect the auditor’s independence.
D. OVERSEEING THE INDEPENDENT AUDIT
The audit committee is responsible for the appointment, compensation, evaluation, and retention of the external auditor. The audit committee should evaluate annually the effectiveness of the external auditor, including verifying the auditor’s independence, the auditor’s knowledge of the financial issues and accounting standards of the industry or industries in which the corporation operates, and the auditor’s effectiveness in providing timely and quality auditing services.
The audit committee should meet with the external auditor during the planning phase of the annual audit to review the plan for the staffing, scope, and cost of the audit and to discuss any areas that may require emphasis or special procedures during the audit. After the audit, the committee should review with the external auditor any problems or difficulties encountered, any significant issues requiring discussion or debate with management during or after the audit, and any letter from the external auditor to management summarizing audit observations together with management’s response to that letter. The audit committee should review the findings of the external auditor with respect to any special audit procedures and determine, with advisors’ assistance as appropriate, whether revisions to particular corporate policies or procedures are required.
The audit committee should understand significant accounting judgments and estimates that materially affect the corporation’s financial statements. Corporations sometimes have a choice among available generally accepted accounting principles or practices. Therefore, the committee should inquire about and understand the effect of alternative choices on reported results. The audit committee should review, at least annually, with the external auditor and with the chief financial officer (CFO) or chief accounting officer (CAO), major issues regarding, and any changes in, choices of accounting principles. Some audit committees find it useful to ask the external auditor to inform the committee what choices the auditor would have made if it, rather than management, had been responsible for preparing the financial statements. The committee also must review with the auditor the quality of management’s accounting judgments.
The audit committee should discuss, often with the participation of the internal auditor, any significant deficiencies or material weaknesses the auditor identified during the course of its annual audit of internal controls. If the auditor identifies any such significant deficiencies or material weaknesses in the company’s internal controls over financial reporting, the audit committee should oversee management’s timely remediation of those deficiencies. If the audit committee fails to do so, the auditor may conclude that the audit committee constitutes a material weakness in the company’s internal controls.
The above-discussed processes and reviews allow the audit committee to determine whether to recommend to the board inclusion of the audited financial statements in the corporation’s annual report on SEC Form 10-K. The company’s quarterly SEC 10-Q reports may not require a similar process, but many audit committees do review these reports before they are filed.
E. INTERACTION WITH INTERNAL AUDIT
The New York Stock Exchange requires its listed companies to have an internal audit function. The internal auditors typically are employees of the corporation, but some corporations outsource some or all of this function to a firm that is not affiliated with its external auditor.
The audit committee should routinely meet, in private, with the senior internal auditing executive to discuss the external audit function and relationship between the internal and external audit programs, to consider any special problems or issues that may have occurred since the last meeting, and to review the implementation of any recommended corrective actions. The committee should approve the internal audit charter, as well as the annual internal audit plan, before the fiscal year begins. The audit committee should ensure that the internal audit function has sufficient staff resources and budget to fulfill its internal audit plan for the coming year.
If the corporation does not have an internal audit function, the committee should consider with management and the external auditor whether to establish one and, if not, how to obtain the benefits and protections of such a function. If the company has outsourced the internal audit function, the committee should meet regularly with appropriate representatives of that service provider, including meeting in executive session.
F. MEETINGS WITH AUDITORS
Although the CFO or CAO normally attends meetings with external and internal auditors, the audit committee should also meet with the external and internal auditors in executive session, without management present. The NYSE requires its listed companies’ audit committees to meet periodically with the external auditor and the head of the internal audit staff, if one exists, separately, in executive session without the participation of other management. These sessions typically cover the following issues, whether (i) the auditors are uncomfortable with any matters regarding the corporation and its financial affairs and records, (ii) the auditors have had any significant disagreements with management, (iii) the auditors have had the full cooperation of management throughout the audit process, (iv) the corporation has reasonably effective accounting systems and controls in place, and (v) the auditor recommends strengthening any material systems or controls or financial staffing. Many audit committees find it useful to have the external auditor describe the two or three issues that involved the most discussion with management during the course of the auditor’s work. The committee may also meet with management to discuss the quality of services provided by the external and internal auditors.
The audit committee should discuss with the external auditor and management its role in reviewing quarterly financial reports. They should also discuss the external auditor’s procedure for raising significant deficiencies or material weaknesses with the committee or its chair.
As part of the auditor’s annual audit of the corporation’s internal control over financial reporting, the external auditor must assess whether the audit committee understands and exercises its oversight responsibility over financial reporting and internal controls. As part of this assessment, the external auditor will consider its interaction with the audit committee, including knowledge about the corporation’s accounting policies and internal controls and ability to monitor any control remediation efforts by management. If the auditor concludes that the audit committee’s oversight is ineffective, the auditor must report that conclusion, in writing, to the full board.
G. MEETING WITH COMPLIANCE OFFICERS
Unless there is another board committee responsible for compliance, the audit committee should meet as necessary and appropriate, and at least once annually, with the officers responsible for implementing the corporation’s codes of business conduct and compliance policies. Officers with compliance responsibilities typically include the general counsel, chief internal audit officer, and chief compliance officer. These officers should meet with the audit committee outside the presence of other executive officers or directors who are not independent. The responsible officers should also report to the committee periodically. The scope and content of such reports should give the committee timely information about the number and type of concerns reported and investigated, any material violations of law or corporate policies, the sanctions imposed, and any other information to enable the committee to monitor the effectiveness of the overall compliance program. In addition, the general counsel should meet regularly with the audit committee, or another committee of independent directors, to communicate concerns regarding legal compliance matters, including potential or ongoing material violations of law by the corporation and breaches of fiduciary duties, violation of corporate policies, or ethical violations by senior managers.
H. ESTABLISHING PROCEDURES TO HANDLE COMPLAINTS
The audit committee of a public company must establish procedures, preferably anonymous and confidential, for employees to report concerns or complaints about accounting, internal controls, and auditing matters, as well as violations of the corporation’s code of ethics. For global companies, the procedures must comply with the privacy regimes of multiple countries. Audit committee members are not usually in the best position to conduct fact-finding or even to receive complaints or concerns in the first instance. Instead, the committee should create, with management’s assistance, procedures adequate to ensure that information reaches the committee in a form conducive to identifying “red flags” and to ensuring timely and efficient committee review and resolution of any issues. For example, the audit committee may decide to rely on an ethics or compliance officer to gather, review, and process information, or it may decide to outsource this task to a third-party service provider.
In addition, lawyers for public companies (both internal and outside counsel) may be required to report to a committee of independent directors, or to the board, credible evidence that a material violation of securities laws, breach of fiduciary duty, or similar violation by the issuer or any of its officers, directors, employees, or agents has occurred, is occurring, or is about to occur. Public companies may determine that the audit committee is the appropriate committee to receive such reports. If so, the audit committee should have a process for acting on reports, including an understanding about arranging for legal advice from outside counsel when appropriate.
I. MEETINGS AND COMPENSATION
The audit committee should discuss and determine the number of meetings it needs to hold annually in order to deal effectively with its responsibilities. The major securities markets’ listing standards require audit committees to review quarterly and annual reports filed with the SEC, and as a result, the audit committee should meet at least four times a year. It is common for public company audit committees to have an in-person or telephonic meeting with the company’s CEO, CFO, other senior financial managers, and external auditor in advance of each quarterly or annual earnings release. As a result, almost all audit committees schedule at least four, and some as many as five to eight, meetings per year.
It is important that the schedule for board and other committee meetings and activities not unduly limit the time for audit committee deliberations. Membership on the audit committee requires a significant commitment of time. Committee meetings are often several hours in length, and some extend for an entire day. As a result, some boards provide the audit committee members with a higher level of compensation, often through meeting fees. Others have determined that differential compensation among board committee members can create the risk of divisions within the board and may make selection of members and rotation of committee assignments more difficult. Nonetheless it is important that audit committee members be compensated adequately for the time and effort they devote to the corporation to fulfill their fiduciary and technical responsibilities as committee members.
SECTION 8: COMPENSATION COMMITTEE
Executive compensation plays a central role in attracting, retaining, and motivating the management talent critical to the corporation’s success. The compensation committee is responsible for approving executive compensation and, in many cases, for overseeing the planning for management succession. The integrity and transparency of the committee’s decision-making process are of paramount concern to shareholders and regulators alike. Real abuses and perceived excesses in executive compensation policies, plans, and programs at some notable public companies led to many of the federal corporate governance reforms related to compensation. For example, investors’ desire for greater transparency in executive compensation in general, and compensation committee decision-making in particular, resulted in the SEC’s complete overhaul of the proxy disclosure requirements for executive compensation in 2006 and 2009, as well as specific requirements in the Dodd-Frank Act in 2010.
The legislative and regulatory, as well as public, scrutiny of the role of executive compensation in connection with (and as a contributing factor to) the recent global financial downturn suggests that shareholder and regulatory interest in executive compensation is not likely to wane. Regulators are now working on rules implementing the executive compensation and corporate governance provisions of the Dodd-Frank Act, which include mandatory say-on-pay votes for all public companies, as well as additional executive compensation disclosures relating to the relationship between the CEO’s total pay and the company’s median employee’s total pay, and the relationship between executive compensation and the company’s financial performance.
These recent executive compensation and corporate governance reforms reflect Congress’s heightened focus on the role of the compensation committee as the primary corporate decision maker for compensation matters. In performing this function, the compensation committee should consider the following questions:
How should compensation packages for the CEO and other senior executives be determined, including (i) who should do the negotiating; (ii) what are the relevant companies, and/or peer companies, with which to compare the corporation’s compensation packages; and (iii) what is the appropriate role, if any, for compensation consultants and other advisors in setting compensation levels and elements?
Is management’s compensation reasonably related to personal and corporate performance, and does it appropriately motivate management to build value for shareholders?
Over time, are the compensation programs and policies attracting and retaining quality management for the corporation?
Do a corporation’s public disclosures about executive compensation give shareholders an accurate picture of senior executive compensation and the reasoning behind executive compensation decisions?
Under what circumstances should the corporation recover previously awarded compensation, and how should the corporation’s compensation “clawback” policy function, given legislative and regulatory requirements, including (i) which officers and employees will be subject to the policy, (ii) what types and amounts of compensation are subject to potential recovery, and (iii) how should the policy be implemented to ensure enforceability?
Are severance, change-of-control, and post-employment benefits properly related to corporate interests and reasonable in amount?
The compensation committee should apply independent judgment to determine the compensation arrangements and levels that are in the best interests of the corporation. When functioning effectively, the compensation committee provides credibility and substance to the concept of independent oversight of executive compensation.
A. MEMBERSHIP
The compensation committee should, and generally must, consist solely of independent directors. The Dodd-Frank Act will require the major securities markets to revise their listing standards to require that compensation committee members satisfy heightened independence standards. In addition, under the federal tax laws, decisions of most public companies to pay certain highly compensated executives more than $1 million annually must be made by directors who meet the Internal Revenue Service’s definition of “outside director” in order for the compensation to qualify for a full federal tax deduction. Moreover, SEC rules exempt executive officer option grants from profit recapture only if “non-employee directors,” as defined in those rules, make the grant decisions. Each of these terms is similar to, but not the same as, the “independent director” definitions in stock exchange listing standards. Consequently, the eligibility of prospective compensation committee members should be reviewed against each standard. Interlocking compensation committee memberships are strongly discouraged, trigger additional proxy statement disclosures, and may disqualify a director from “independent” status under listing standards. For example, if an executive officer of a corporation serves on the compensation committee of another company, and an executive officer of that other company serves on the first corporation’s compensation committee, they are considered to be “interlocking.”
Apart from legal considerations, the compensation committee’s independence from management gives greater credibility to the compensation committee’s key responsibility: to establish and approve compensation for executive officers on behalf of the corporation. Further, even when a director meets the independence requirements of the applicable listing standards, close personal or business ties between the director and the CEO may mean, or at least create the appearance, that the director is not an appropriate member of the compensation committee. As with board membership generally, diverse backgrounds, expertise, and experiences can provide useful perspectives in compensation committee deliberations.
B. PRINCIPAL FUNCTIONS
The principal functions of the compensation committee are to:
oversee the corporation’s overall compensation structure, philosophy, policies, and programs and assess whether they establish appropriate incentives for senior executives;
review and approve corporate goals and objectives relevant to the CEO and senior executive compensation and annually evaluate executive performance in light of those goals and objectives;
establish the compensation and benefits of the CEO and executive officers;
assess how compensation policies and programs contribute to or affect the company’s risk profile and structure them to create incentives for management to make risk-appropriate decisions;
evaluate and approve employment agreements with executive officers;
establish and periodically review policies for the administration of executive compensation programs (including all equity-based plans and perquisites);
make recommendations to the board with respect to incentive compensation plans and equity-based plans generally;
review and be satisfied with the corporation’s Compensation Discussion and Analysis disclosure and discuss with management any issues or questions arising from that review;
review and approve the annual report of the compensation committee for inclusion in the annual meeting proxy statement; and
conduct an annual self-evaluation.
1. Decision-Making Process
The compensation committee independence requirement is designed to promote objective judgment on the sensitive matter of management’s compensation, and in particular, the compensation of the CEO. At a minimum, the compensation committee should create a thorough process to reach an informed decision that is something more than rubber-stamping somebody else’s recommendations. How much more, of course, depends on the compensation committee’s judgment, as well as the facts and circumstances of the situation.
A compensation committee should consider the most effective process for reaching an independent and informed decision about the appropriateness of the amount and composition of management’s compensation packages. The compensation committee may benefit from engaging and collaborating with competent, experienced, and independent compensation consultants, who can assist in collecting comparative data and advise on the best compensation packages for the corporation. Indeed, the Dodd-Frank Act authorizes compensation committees to retain and oversee independent advisors. Regardless of whether the committee engages outside consultants or counsel for assistance, the committee is ultimately responsible for approving the terms, amounts, and forms of compensation.
Utilizing the resources of advisors, particularly those engaged by the compensation committee and independent of the company and senior management, can give credibility and substance to the independent oversight of executive compensation. The type of advisors and the extent of their use can vary depending on each executive’s position within the company and on a variety of other facts and circumstances. For example, an outside CEO brought in to lead the company may warrant a different process than the lifelong insider of many years. In addition, if an executive engages his or her own lawyer to negotiate the terms of the employment agreement, the compensation committee should consider how best to protect the corporation’s interest in the process—for example, engaging its own or company counsel to help negotiate the agreement.
Management’s participation in the compensation committee’s decision-making process is a particularly sensitive area. Although a company’s CEO will often meet with the compensation committee, she or he should not be present during most of its deliberations and should never be present during deliberations regarding his or her own compensation. The same is true of the corporation’s general counsel and senior compensation or human resources executives. Both the reality and the appearance of independent oversight are important; therefore, it is wise to have compensation committee discussions on executive compensation matters occur without members of management present. The committee should consider the CEO’s compensation in a private session, without the CEO or the CEO’s subordinate officers.
With respect to compensation policies and decisions for non-employee members of the corporation’s board of directors, the best practice is for the entire board to make or approve the policies and decisions, rather than just the compensation committee.
2. Structure and Components of Executive Compensation
The basic principle that a significant portion of an executive’s compensation should be tied to the corporation’s strategic objectives and financial performance, with an appropriate balance between short- and long-term incentives, should guide the compensation committee. The structure and components of an executive compensation package vary among industries and companies. Benchmarking against peer companies is sometimes used as a tool to help determine executive compensation, but the committee should avoid simply matching or exceeding the compensation structure of peer companies. In addition, peer companies should be selected carefully, with company size, financial condition, industry characteristics, competitive factors, location, and corporate culture as relevant factors. Many companies have compensation consultants prepare summaries focused on the regions in which the companies compete for talent, the industries within which they principally work, and their market capitalization. Some companies may also use more than one peer group for executives, if the markets for which the companies compete for executive talent differ for one or more positions.
Compensation committees have a wide variety of tools for equity incentives, such as restricted stock, restricted stock units, stock appreciation rights, stock options, and other types of equity compensation. Although historically stock options were commonly used because there was no charge to earnings associated with the grant of “at the market” stock options, current accounting rules now require companies to recognize a non-cash expense in connection with all stock options, thereby eliminating the accounting benefit of granting options as compared to other forms of equity compensation. In addition, overhang strains and the economic downturn in late 2008 left many previously granted options under water and considerably weakened the existing incentives. Consequently, some compensation committees have begun to grant other forms of equity compensation, such as restricted stock or restricted stock units, or awards that vest to a greater extent in later years or vest only when recipients meet specified performance goals. In choosing the form and vesting schedule and conditions of an award, compensation committees should carefully consider whether the award provides the intended incentive, for example, by taking into account other awards already held, including the exercise prices and vesting of such awards, the accounting expense of the award, the tax effect of the award both for the company and the individual, and the administrative complexity of the award.
Compensation committees also often require retention or holding periods for stock, whether granted or obtained on option exercise. This can help to align executive pay more effectively with long-term performance. Many companies also establish stock ownership targets to further align the executives’ interests with those of shareholders. Some companies prohibit activities that attempt to hedge against a decrease in the value of the company’s equity securities. The Dodd-Frank Act requires that companies disclose whether employees or directors may engage in hedging transactions.
The compensation committee should also review the benefits and perquisites provided to senior executives, particularly when approving employment contracts. “Perks” have received considerable attention due to perceived excesses in their use, such as personal use of a corporate aircraft, tax gross-ups, and use of company resources post-employment. As a result, the SEC requires enhanced disclosure of perks. Another important area of scrutiny is retirement, termination, and change-in-control benefits. There is widespread shareholder concern that these benefits are not sufficiently related to job performance, and compensation committees should be aware that these benefits could be viewed as excessive even when fully disclosed in the annual Compensation Discussion and Analysis. For example, some institutional investor groups now recommend that constituents withhold votes from, or even vote against, members of the compensation committee or board of directors that approve a new or materially modified employment agreement that includes a tax gross-up.
In addition, committee members should understand the interplay of all compensation arrangements—fixed, incentive, benefits, perquisites, deferred compensation, retirement, severance, and change in control—so that unintended or disproportionate benefits do not accrue to the senior executive. To facilitate this understanding, at many public corporations senior management or independent compensation consultants annually provide committee members with a clear and comprehensive presentation detailing all elements and amounts of compensation paid to each senior executive, as well as the value of potential retirement, severance, and change in control benefits to which the executive could become entitled (sometimes referred to as a “tally sheet”). The SEC’s 2006 compensation disclosure rules increased the need for an accurate computation of these amounts. These rules require public corporations to disclose details about the dollar value of all elements of executive compensation, as well as estimates of benefits that could become payable to senior executives either upon a termination of employment or upon a change in control of the corporation.
The compensation committee also has a role in risk oversight for company compensation policies and practices. Under the 2009 SEC executive compensation rules, companies must analyze their compensation policies and practices and disclose whether those policies and practices encourage excessive risk taking and are reasonably likely to have a material adverse effect on the company. In most companies, management, in some cases working with compensation consultants, prepares this analysis and makes the initial determination regarding the companies’ policies and practices by tallying all of the elements of compensation, determining the risks posed by each element, and then analyzing any mitigating factors. The compensation committee, however, retains an oversight role, and management should detail its procedures for committee approval and provide the committee with a summary of its analysis and determination. In some cases, the compensation committee may want to take a more active role in risk oversight for compensation policies and practices by reviewing and approving management’s comprehensive analysis or even conducting its own analysis with input from its compensation consultants.
The proper design of a compensation program is just the starting point. The program requires at least annual performance evaluations of the participating executives against pre-established performance targets (which may include comparison against the performance of peer corporations), as well as ongoing review of the program’s effectiveness. The compensation committee should keep the board informed of the results of these periodic reviews.
3. Documentation of Approval of Executive Compensation
The compensation committee should review with senior management the corporation’s procedures for accurately and timely documenting the grants or issuances of equity awards, both in the compensation committee’s minutes (or other written action) and in the documentation evidencing the awards. Detailed compensation committee minutes or resolutions that adequately discuss the compensation committee’s rationale, deliberation, and consideration regarding the grants or issuances of equity awards and any other form of executive compensation, are considered best practices and can assist the corporation in the preparation of its annual Compensation Discussion and Analysis. As a general matter, a corporation should have adequate written procedures relating to the grants or issuances of equity awards, including the timing and pricing of such grants or issuances, to help protect the corporation, its executives, and the compensation committee against claims of manipulation or abuse in the timing or pricing of such grants or issuances of equity awards. Best practices also include granting equity awards at pre-scheduled meetings that fall outside of company blackout periods for employee trading of company securities and avoiding the use of actions by written consent and delegation to officers.
4. Legal Restrictions on Executive Compensation
The compensation committee should become familiar with and receive legal advice as to legal restrictions on compensation to officers and directors, whether under a shareholder approved plan or otherwise. The Sarbanes-Oxley Act prohibits most personal loans and extensions or arrangements of credit from a public company to its directors and executive officers. In addition, the Dodd-Frank Act requires that companies adopt a “clawback” provision, applicable in the event of a restatement of financial statements, providing for recovery of excess amounts of any bonus or other incentive- or equity-based compensation received during the three-year period preceding the restatement. The clawback provision must cover all current and former executives.
Regardless of the requirements of the federal securities and other laws, in circumstances in which there has been a restatement indicating that the bases on which incentive-based compensation has been paid are no longer correct, the compensation committee or other independent directors should consider whether to recover any compensation on the basis of unjust enrichment. In addition, if the restatement resulted from employee misconduct, the compensation committee or other independent directors should consider whether to take action to discipline or dismiss, as well as to recover compensation paid to, any employee involved in the misconduct.
To assist with the recovery of such compensation, and in light of mandatory clawback provisions, the compensation committee should consider incorporating clawback provisions into the terms of incentive compensation programs or arrangements. For example, the provisions could, in certain circumstances, contractually obligate the employee to return any such compensation to the corporation. In particular, and in light of recent legislation, the compensation committee should determine the circumstances under which the corporation would be entitled to clawback, including determining the eligible employees and types and amounts of compensation to be subject to the policy, as well as determining how to implement the policy, accounting for enforceability factors. The compensation committee should consider the potential effect of compensation provisions on its ability to attract and retain executives and on investor and shareholder concerns regarding the corporation’s executive compensation programs and arrangements.
C. DISCLOSURE OF COMPENSATION DECISIONS
Public company managers must prepare a section of the annual meeting proxy statement called Compensation Discussion and Analysis, which is a detailed discussion of the key elements of the corporation’s executive compensation policies and decisions. This disclosure discusses the principles underlying executive compensation decisions and should include a discussion regarding the rationale behind the adoption of such principles and explain executive compensation decisions in light of the principles. The Dodd-Frank Act requires a non-binding shareholder vote, at least once every three years, to approve compensation of named executive officers. This vote will take place at annual or other shareholder meetings for which the SEC requires disclosure. In addition to this say-on-pay vote, the legislation also requires a non-binding vote every six years to determine the frequency of say-on-pay votes.
The Compensation Discussion and Analysis must include a discussion of the following:
the objectives of the corporation’s compensation programs;
the results the compensation program is designed to reward;
the elements of compensation;
the reasons the corporation chose to pay each element;
the manner in which the corporation determines the amount (and the formula, if any) for each element of pay; and
the way each compensation element and the corporation’s decisions regarding that element fit into the corporation’s overall compensation objectives and affect decisions regarding other compensation elements.
The compensation committee should scrutinize closely the corporation’s policies and procedures relating to the disclosure of executive officer compensation. Consultation with external compensation specialists may be necessary to assist the committee in formulating the Compensation Discussion and Analysis. Because the committee makes many decisions for senior executives outside the presence of management, the committee should assist management in its preparation of the Compensation Discussion and Analysis (for example, by providing detailed minutes that reflect and highlight the various factors it weighed and considered) and then review and be satisfied with the disclosure’s accuracy. The compensation committee must also state, in a separate report in the proxy statement, that its members have reviewed and discussed the Compensation Discussion and Analysis with management and, based on this review and discussion, recommended that it be included in the proxy statement.
The compensation committee should also work with management and review management’s analysis and assessment of whether compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. The compensation committee should seek appropriate assurances from management and legal counsel that all disclosures required by law and by the applicable national stock exchange listing standards are being made, and that rules related to shareholder approval of equity compensation plans and the reporting of grants of and trades in the corporation’s securities are being observed. The compensation committee, along with counsel, should discuss and consider how to document adequately the process leading to the compensation disclosures in a manner that supports the disclosures made.
In addition, the Dodd-Frank Act requires companies, depending on their status, to make specific disclosures, including:
indicating whether the committee retained a consultant and its consideration of the factors for doing so (listed companies, but controlled companies exempt);
indicating whether the committee’s work has raised any conflicts of interest, and if so, how they were resolved (listed companies, but controlled companies exempt);
demonstrating the relationship between executive compensation and financial performance (public companies);
stating the ratio between the CEO’s compensation and the median compensation of all other employees (public companies); and
indicating whether, as discussed above, certain hedging transactions are permitted (public companies).
The SEC will promulgate further regulations in this area, including specific regulations for financial institutions, and the national securities markets are required to issue related listing rules.
D. INDEPENDENT ADVICE FOR THE COMPENSATION COMMITTEE
The Dodd-Frank Act requires that committees have the power to hire (without management influence in the selection process) compensation specialists, consulting firms, or other experts to assist in the evaluation of executive officers and the development of a compensation program so that it need not rely solely upon management-selected corporate personnel or outside specialists for advice and guidance.
Given increased public scrutiny and the most recent executive compensation and corporate governance reforms, including those in the Dodd-Frank Act, relating to the need for compensation committees to obtain advice from independent advisors, the committee should consider the following types of factors prior to engaging an advisor: (i) the other services performed by the advisor for the corporation, (ii) the amount of fees paid to the advisor for such services, and (iii) the existing personal and business relationships between the advisor and the corporation, including with management. At all times following the engagement, the compensation committee should be made aware of any new relationships that develop between the advisor and the corporation or management.
The compensation committee’s need for independent advice is particularly critical when the compensation committee exercises its obligations with respect to reviewing and approving employment, retention, change-in-control and/or severance agreements with executives. As a result, for example, the Dodd-Frank Act requires the compensation committee to have full authority, stated in its charter, to approve its advisors’ fees and other terms of engagement and should make clear that the advisors work for the compensation committee, not management. Compensation consultant fees and other services by the consultant must be publicly disclosed in certain circumstances. The advisor should have direct access to the compensation committee, without the presence of management, to help preserve the advisor’s independence. Outside advisors should also have direct access to senior executives in order to obtain information necessary to provide the compensation committee with independent advice.
E. OTHER RESPONSIBILITIES
Other responsibilities that the compensation committee may undertake include reviewing and monitoring the effectiveness of employee pension, profit sharing, 401(k), and other benefit plans and programs, taking into account the importance of retaining, motivating, and incentivizing the employees of the corporation, as well as the overall cost to the corporation of such programs. Compensation committees should carefully consider whether they are or should be fiduciaries with respect to the corporation’s pension, 401(k), or other employee benefit plans that are subject to regulation under the Employee Retirement Income Security Act (ERISA). Under ERISA, plan fiduciaries are subject to heightened scrutiny and responsibility with respect to the investment of plan assets. The compensation committee has a duty to be informed about the corporation’s compensation and benefit structure; however, most compensation committees do not act as fiduciaries for ERISA-covered benefit plans. Directors and high-level executives typically are privy to non-public information regarding the corporation’s performance and finances. As a result, they can be in the difficult position of having to choose between their duties as officers or directors under state and federal laws to keep such information confidential, and their duties as plan fiduciaries possibly to disclose or act upon such information for the benefit of plan participants. Often, rather than having directors or senior officers designated as plan fiduciaries, corporation employees (but not the most senior executives) will serve as the fiduciaries of the corporation’s ERISA-covered benefit plans. Increasingly, however, corporations are engaging independent fiduciaries to make some or all of the investment decisions for their ERISA-covered benefit plans. This separation can help insulate the corporation from potential conflicts of interest related to such investment decisions, particularly with respect to any decisions to invest plan assets in the stock of the corporation.
SECTION 9: NOMINATING AND GOVERNANCE COMMITTEE
An effective nominating and corporate governance function is critical to board performance. This committee’s stature and importance has increased with the growth in company size, investor focus on board composition and performance, and the financial crisis. It also has transformed into a corporate governance committee or a nominating and governance committee.
Major securities markets’ listing standards prescribe some elements of the nominating and corporate governance function. Generally, the committee is responsible for recruiting and maintaining board members with the appropriate skills and independence for quality decision-making. It also implements and oversees the operation of corporate governance principles for both board process and the corporation’s business.
A. MEMBERSHIP
The nominating and governance committee should be composed solely of independent directors. The NYSE requires that each of its listed companies has a committee composed entirely of independent directors, with a written charter that addresses the committee’s process to identify individuals qualified to become directors, to select, or to recommend that the board select, director nominees, and to develop and recommend to the board a set of corporate governance principles for the corporation. NASDAQ rules do not mandate a nominating or corporate governance committee but do require that either a committee of independent directors (subject to limited exceptions) or a majority of independent board members select or recommend director nominees. As a practical matter, because SEC rules require public disclosure of reasons for a corporation’s lack of a nominating committee, virtually all NASDAQ companies maintain such a committee.
B. CRITERIA FOR BOARD MEMBERSHIP
A nominating and governance committee should establish, or recommend to the board, criteria for identifying appropriate director candidates. These criteria are usually in governance principles or a separate policy. The committee should lead the recruitment and selection process. The attributes of an effective corporate director include strength of character, an inquiring and independent mind, practical wisdom, and mature judgment. In addition to these personal qualities, the committee may want to emphasize individual qualifications such as diversity, technical skills, career specialization, specific industry experience, or expertise in matters such as compensation or governance. The effective nominating committee seeks director attributes to complement and expand the attributes of the existing board members. Of course, the committee must address certain requirements, such as identifying a director who qualifies as an “audit committee financial expert” for accounting and financial reporting purposes, or explain why it does not have such an expert. Public companies are also emphasizing diversity considerations in their desired board profile, recognizing that diversity can contribute significant value by providing additional perspectives to board deliberations. The articles or certificate of incorporation, bylaws, or board policies may include other qualifications for directors, such as age or length of service limitations or relevant experience.
There is no one-size-fits-all approach to director searches. The desired outcome is a board that can build consensus and effectively exercise collaborative judgment. Some boards also look for specific skills and experiences to build on what they currently possess, lack, or need to strengthen. This type of focus can help direct the search toward candidates who can provide needed additional talent and experience to the corporation.
Most corporate governance commentators recommend that a board of a public company have a substantial majority of independent directors, and the major securities markets require at least a majority of independent directors. When considering director independence, the committee should also bear in mind broader judicial standards of disinterestedness applicable for judicial review of conflict of interest or other issues. As a result, the committee should evaluate the full range of business and personal relationships between director candidates and the corporation and its senior managers.
Although independent directors are essential to a well functioning board, the board must be able to receive candid input from senior management. In addition to input from the CEO, who is typically on the board, the committee should consider how best to have access to senior management to ensure that input. Some nominating and governance committees determine that senior officers, in addition to the CEO, should serve as directors, whereas others decide that attendance at board or committee meetings by senior officers in a non-director capacity is sufficient to facilitate the board’s ready access to information regarding the business and operations of the corporation. Although it is not typical to have senior executives, beyond the CEO, on the board, in an appropriate case, their presence can serve to enhance succession planning and facilitate a peer relationship and firsthand contact.
C. EVALUATING BOARD INCUMBENTS
The nominating and governance committee is also responsible for evaluating incumbent directors. The committee should thoughtfully consider each director’s contribution and the needs of the board before deciding whether to recommend renomination. This is a good practice and can help address the common criticism that election or appointment to the board is tantamount to tenure. It is also responsive to SEC disclosure rules requiring disclosure of director qualifications justifying service. The committee should consider attendance, preparation, participation, and other relevant factors. Tools to assist in the evaluation process may include confidential discussions led by the board chair, lead director, or corporate governance committee chair, self-evaluations, and peer evaluations. Outside consultants can also be effective in the evaluation process.
Boards handle the sensitive issue of board succession, including underperforming directors, in a variety of ways. Many boards attempt to deal with the issue indirectly through the adoption of mandatory retirement policies, but these policies can create an expectation that board service continues until retirement. In fact, a well-functioning nominating committee should be able to decline to nominate incumbents for reelection as individual situations dictate.
D. NOMINATING DIRECTORS
The nominating and governance committee approves and selects, or recommends that the board select, director nominees, including both incumbent directors and new candidates. The committee also recommends candidates to the board to fill interim director vacancies.
The committee should encourage all directors, including management directors, to suggest candidates for the board. The committee should also seek out candidates and can employ search consultants to assist in identifying appropriate candidates. The committee’s charter should give the committee the authority to retain a search firm to identify director candidates, including the authority to approve the search firm’s fees and other retention terms. The committee should control the process, including making decisions with respect to nominees and recommending to the full board a slate of nominees. Moreover, the committee should be the conduit for communication regarding shareholder recommendations for director nominees. The board’s comprehensive plan for shareholder communications may encourage the committee to seek suggestions for director candidates from its institutional investors and other shareholders. Both the non-executive chair, if there is one, or a lead or presiding director and the nominating/corporate governance committee chair should be prominently involved in the recruiting process in order to ensure that the committee is making nominating decisions and not the CEO or other insiders.
Public company proxy statements must disclose the nominating and governance committee’s procedures and policies for considering director candidates, as well as the particular experience, attributes, skills, and qualifications the committee focused on in selecting or recommending each director candidate. Indeed, the proxy statement affords a board the opportunity to explain why it believes a nomination is warranted. Furthermore, public companies must disclose whether, and if so, how, the nominating and governance committee considers diversity in identifying director nominees. If the nominating/corporate governance committee has a diversity policy, the company must disclose how the policy is applied and how the committee assesses the policy’s effectiveness. The purpose of these disclosure requirements is to increase shareholder understanding of the nominating process. Accordingly, the committee should review its procedures and policies to ensure that they are consistent with the committee’s circumstances and operations and that they are sufficiently formalized to provide that understanding and to satisfy the scrutiny of public disclosure.
E. RECOMMENDING COMMITTEE MEMBERS AND CHAIRS
In addition to nominating directors, the nominating and governance committee will often make recommendations to the board regarding the responsibilities and organization of all board committees. The committee should also recommend qualifications for membership on committees. The committee may also make annual recommendations of specific individuals for membership on standing committees. Although some boards have a policy of periodic rotation of committee memberships among the directors to develop expertise and allocate equitably the time commitment, rotation may be more difficult for the audit committee than for others. The committee should also address the process for board decision-making regarding the appointment of and changes in the chair and members of each board committee.
F. CHIEF EXECUTIVE OFFICER AND OTHER MANAGEMENT SUCCESSION
One of the most important functions of the board is selecting and assessing the CEO and planning for CEO and other executive officer management succession. Ongoing planning for what happens in the event of a vacancy in leadership is a critical board responsibility. The nominating and governance committee should be prepared and qualified to lead this process.
The choice of a new CEO is fundamental to the direction of the company. The CEO is primarily responsible for implementing the corporation’s strategic vision with input and guidance from the board. The CEO is also responsible for the short- and long-term performance of the corporation. The CEO will establish in large part the “tone at the top” for legal compliance and ethical standards. Finally, the CEO is generally responsible for the selection and direction of other members of senior management. Consequently, the board must select and continually assess the CEO with care and due consideration for the challenges facing the corporation. The board must monitor the CEO’s performance and determine when there is a need for a change in senior management in light of executive performance and the corporation’s challenges.
The nominating and governance committee often has the responsibility to recommend to the board a selection process or a successor to the CEO in the event of retirement or termination of service. The committee may also review and approve proposed changes in other senior management positions, with the understanding that the CEO should have considerable discretion in selecting, retaining, and reviewing members of the management team. In order to perform these functions, the committee, or another board committee, should, at least annually, review the performance of the CEO and members of senior management.
Succession planning is a continuous board activity that is closely related to management development. The board should be aware of, and regularly reassess, how long the current CEO is likely to continue, what developments may cause a change in that expectation (including a shift in strategy, a change in performance, or an emergency or crisis). The board should also consider what might cause the CEO or other senior executive officers to consider leaving the company. Although all of these factors are relevant, succession planning is in fact a continuous process and one that, by definition, rarely results in a hard and fast plan for a specific outcome. As a result, two key components of succession planning are assessing and developing other management talent and considering what steps the CEO and other senior executive officers can take to further develop their own leadership capabilities and those of their direct reports.
Decisions about succession planning and management development should be closely related to corporate strategy, because the leadership group must have both a clear understanding of the corporate strategy and the ability to implement it. In addition, the committee should ensure the succession plan includes emergency procedures for management succession in the event of the unexpected death, disability, or departure of the CEO. The plan should also incorporate a review, with the CEO, of management’s plans for the replacement of members of the senior management team, as well as the CEO’s assessment of the ability of team members to lead, whether on an interim or longer basis, should the CEO be incapacitated.
G. OTHER COMMITTEE AND CORPORATE GOVERNANCE FUNCTIONS
As mentioned previously, the nominating and governance committee has increasingly assumed responsibility for ensuring that the corporation has adopted, maintained, and regularly updated principles and policies of corporate governance. In addition to addressing director nomination or renomination, committee membership, and management evaluation and succession, the committee typically addresses the following tasks and issues:
developing, recommending to the board, and monitoring a statement of corporate governance principles or guidelines (required of listed companies by NYSE);
developing proposals for amendments to bylaws and other governance documents;
developing policies to respond to shareholder proposals;
evaluating the effectiveness of individual directors, the board, and board committees (also required by NYSE);
evaluating director standards of independence and monitoring director compliance with those standards;
providing for director orientation and education programs;
reviewing the board’s leadership structure;
reviewing the board committee structure, including each committee’s recommendation regarding its charter and size and the possible addition of other committees, such as finance, public policy, or risk management committees;
reviewing and making recommendations with respect to the corporation’s director policies, such as compensation, retirement, indemnification, and insurance;
examining board meeting policies, such as meeting schedule and location, meeting agenda, presence and participation of non-director senior executives, and materials distributed in advance of meetings; and
establishing and overseeing procedures for shareholder communications with directors.
H. BOARD LEADERSHIP
As discussed in Section 5 above, many companies that do not have an independent non-executive board chair often designate an independent director as a presiding or lead director or another designation indicating a leadership role among independent directors. This director can be a helpful counterweight to a strong CEO and can ensure that there is an appropriate flow of information to all board members. The nominating and governance committee should consider the appropriateness of such a designation, and if it concludes that it should propose a candidate, it should do so, along with a description of responsibilities. In many cases, the chair of the nominating and governance committee may be the appropriate person for this leadership role. Federal securities laws and regulations require companies to disclose their board leadership structure and the rationale for it.
I. DIRECTOR COMPENSATION
Either the nominating and governance committee or the compensation committee should periodically evaluate the form and amount of director compensation and make a recommendation to the board about it. The committee can seek the advice of outside compensation consultants to assist it. Directors have an unavoidable conflict of interest in fixing their own compensation, and they cannot eliminate the conflict by having management or a compensation consultant suggest the programs. Directors nevertheless have the responsibility to determine their own compensation, so they must ensure they have considered the information necessary to reach a fair decision, including data on peer companies and an analysis of any factors relating to their particular circumstance, such as the complexity of the company and the expected time commitment.
Director compensation programs should align the directors’ interests with the long-term interests of the corporation. Director compensation may take a number of different forms, including annual stock or cash retainers, attendance fees for board and committee meetings, deferred compensation plans, stock options, and restricted stock grants. Additional compensation for additional service, such as for serving as chair of a committee, serving on an ad hoc special committee, or serving on a particularly active committee, is also common. There is, however, a trend away from fees for individual meetings. The corporation’s executives generally do not receive additional compensation for board service.
SEC proxy disclosure rules require detailed disclosure of all elements of director compensation, including perquisites and charitable donation programs. Any non-monetary items, such as stock options or restricted stock grants, require estimates. Any consulting or other agreements with directors and any payments to directors for consulting or other services beyond the regular directors’ fees can impair independence and require disclosure in the annual proxy statement.
The board should be sensitive to and avoid compensation policies or corporate perquisites that might impair the independence of its non-management directors. To maintain directors’ focus on proper long-range corporate objectives, most corporations now pay some component of compensation in the form of restricted stock grants and, although there is a shift away from them toward other equity, stock options. The rationale is that these forms of equity compensation strengthen the directors’ interest in the overall success of the corporation and better align their personal interests with those of shareholders. Options alone do not involve acceptance of any economic risk by a director. Therefore, some companies require directors to purchase a minimum amount of stock in the open market or to accept at least a designated portion of their compensation in stock grants rather than cash. In addition, some companies have policies requiring directors to hold, for a minimum period, shares resulting from the exercise of stock options (less sales necessary to fund option exercise and pay commissions and taxes). Although directors’ retirement arrangements, insurance policies, and educational or charitable gift programs were once widespread, the increasing perception is that they are not related to corporate performance. As a result, their role in compensation has been reduced or discontinued.
SECTION 10: RELATIONSHIP BETWEEN THE BOARD OF DIRECTORS AND SHAREHOLDERS
A. NATURE OF THE BOARD/SHAREHOLDER RELATIONSHIP
Shareholders have become more engaged in recent years in the exercise of their rights, particularly their right to elect directors and to participate in annual and special shareholder meetings. Institutions, rather than individuals, are the primary shareholders of large and midsize public corporations, and many of these institutions owe fiduciary duties to their own investors or beneficiaries, which may include exercising their voting rights. Some of these institutions seek to influence the boards of public corporations on key governance decisions, viewing governance advocacy as a tool to improve portfolio performance. Hedge funds have also engaged in shareholder activism to promote a strategy or outcome consistent with their economic interests. The removal of regulatory barriers to communication and coordination among shareholders and the ease of communication in the internet age have aided shareholders who seek to engage in advocacy, persuasion, and other forms of activism. Moreover, institutions often rely on proxy advisory firms in whole or in part, and this has increased the influence of these firms in voting decisions.
Although the shareholder base of a public corporation is typically a fluid mix of unaffiliated investors with varying interests, the board has the duty to act in the best interests of all shareholders, no matter who nominated the director or the director’s affiliation. Shareholders are concerned about a wide variety of corporate governance issues, including the qualifications and composition of the board, executive compensation, financial reporting, the structure of the director election process (e.g., majority voting, proxy access, and the like) and related charter and bylaw provisions (e.g., staggered board and special meeting provisions), other defensive measures (e.g., rights plans), and board leadership (including the question of whether to split the positions of board chair and CEO). Shareholders may submit proposals to the company with regard to one or more of these issues, seeking to change current corporate governance policies. The proposals may be either binding (like bylaw amendments consistent with shareholder rights) or nonbinding. Although shareholders may not have uniform views about any particular governance issue, such proposals, even if advisory, sometimes garner significant shareholder support despite management opposition.
Shareholder advisory firms have policies on a variety of corporate governance issues and publish ratings of a corporation’s governance based on the perceived compliance with the advisory firm’s policies. These policies often change over time, requiring a continued focus on current governance trends. The advisory firms also recommend votes against directors, or in favor of a “withhold” vote, if the corporation’s policies are inconsistent with the advisory group’s established positions on a particular matter. Indeed, shareholder advisory firms often support shareholder proposals, and in the event the advisory proposals pass, but are not implemented by the corporation, the firms have recommended a vote against the directors in future elections.
Boards may want to address many of the governance issues of concern to shareholders on their own initiative before being pressured to do so. In assessing governance trends and shareholder proposals, boards must exercise their business judgment, adopt governance changes or improvements appropriate for their company given its circumstances, and resist governance changes that are inappropriate for the company.
Boards may also want to develop communication policies or protocols to promote dialogue with or facilitate receipt of input from shareholders. For example, shareholder groups may request an audience with the lead director, the independent directors, or an independent board committee to discuss various corporate governance issues and concerns. Boards need to consider appropriate policies to respond to such requests. Some boards meet with certain key shareholders from time to time to listen to their views and concerns. These efforts should augment but not replace efforts to ensure that shareholders are informed of the company’s efforts toward achieving long-term goals and strategic objectives. The annual meeting also serves as an occasion for information gathering and outreach to shareholders, and some boards encourage directors to engage shareholders in that environment. In moments of crisis, the board may also need to communicate directly to shareholders.
In any communications or meetings with shareholders, boards must consider confidentiality requirements and Regulation FD compliance, as well as the corporation’s disclosure posture on various issues. Moreover, the board must keep in mind that the executive officers of the company carry out the day-to-day management. The CEO or other designated officer should generally be the spokesperson for the corporation on topics relating to the corporation’s business, to assure that the corporation conveys a consistent message. Finally, directors must remember that the board acts only as an entity, and any communication policy should consider how to ensure that the board’s views are conveyed with one consistent voice.
B. ELECTION PROCESS
As noted above, once elected by the shareholders (or otherwise appointed to the board), directors have a duty to act in the best interests of the corporation to the exclusion of their own interests. Directors are accountable to the corporation’s shareholders who, if dissatisfied with the directors’ performance, can, depending on state law and the articles or certificate of incorporation and bylaws, vote against reelection (or withhold votes as a protest) or, in cases where the articles and bylaws allow, remove directors from office even before their terms are over.
Directors generally serve for a one-year term or, if a corporation’s articles or certificate of incorporation provide for a classified or “staggered” board, for longer. Typically, directors on a classified board serve for staggered three-year terms. The principal benefit of a classified board is to ensure continuity of leadership. In recent years, shareholder activists have criticized classified boards. Classified boards can operate as a takeover defense, because, for example, under some state statutes directors on a classified board can be removed only for “cause” unless otherwise provided in the articles or certificate of incorporation. As a result, it may be difficult for shareholders to unseat directors in the period between elections. As with most aspects of corporate governance, there is no single answer as to the appropriateness of a classified board.
Traditionally, directors have been elected by a plurality vote, which means that the candidates with the highest number of votes in their favor are elected, up to the maximum number of directorships up for election. This standard ensures a successful election. Plurality voting is gradually losing ground as the predominant standard for uncontested director elections as many boards, including a significant percentage of the Fortune 100, have adopted a majority voting standard. There are numerous possible formulations of majority voting but, in general, under a majority voting standard a candidate must garner more votes cast in favor than against. Many companies have adopted majority voting, either in their articles or certificate of incorporation or bylaws or as a board policy (which retains plurality voting as the underlying standard for election, but requires candidates who fail to receive a majority of the votes cast to tender their resignation to the board). Plurality voting continues to apply to contested elections.
Boards implementing a form of majority voting need to consider the possible consequences of a majority against/withheld vote, including mechanisms to ensure that the board continues to be able to function effectively in the face of that vote. Most corporations adopting majority voting seek to retain some flexibility for the board through application of holdover rules and policies to allow the independent directors of the board to determine whether to allow the director to continue to serve. Of course, the board must act in the best interests of the corporation and its shareholders in making this decision.
The vast majority of elections for corporate directors are not contested. Incumbent directors (in many cases on recommendation by a nominating committee of the board) choose and nominate a slate and recommend that the shareholders vote for it. Although shareholders have the right to nominate their own candidates, the solicitation of proxies from other shareholders is typically necessary in order for such candidates to have any chance of being elected. This solicitation must comply with the SEC’s proxy solicitation rules, including the filing and dissemination of separate proxy materials. The process can be relatively expensive and time-consuming. Further, the outcome of a proxy contest is uncertain, and there are no guarantees that replacement directors will perform any better than the incumbents. Therefore, election contests, even the running of one or two directors (a so-called short slate), are not lightly—or very often—undertaken.
In recent years, shareholders have relied increasingly on “withhold the vote” or “vote against” campaigns to signal disapproval of board candidates or of board policies, instead of seeking to run and elect alternative nominees. These negative campaigns can be powerful catalysts for change. Although the results do not affect the legal outcome of the election in a plurality vote system when there are no competing candidates, there have been some prominent instances in which a large percentage of “withheld” or “against” votes from one or more candidates were followed by a change in the board composition, including the resignation of the affected candidates. Recent changes in law may facilitate contested director elections using only the corporation’s proxy materials, in effect making the corporation’s proxy a “universal proxy.” One purpose of these changes is to address the issues of expense and complexity that make a full proxy contest relatively rare, as noted above. The changes also seek to make it easier for shareholders to promote the election of one or more directors in opposition to the corporation’s director nominees. Thus, for example, Delaware law permits a corporation to adopt a bylaw to facilitate a shareholder’s access to the proxy statement, and subject to conditions specified in the bylaw, require the corporation to include in its proxy materials one or more nominees submitted by shareholders. The bylaws may limit this right to a minimum level of record or beneficial stock ownership and may also include other conditions such as the number or proportion of directors nominated by a shareholder or whether the shareholder has previously sought to require inclusion of its nominees. Delaware law also permits bylaws to reimburse shareholders’ proxy expenses subject to established conditions. The Corporate Laws Committee has adopted similar changes to the Model Business Corporation Act. Finally, pursuant to the Dodd-Frank Act, the SEC has adopted proxy access rules, which, if they become effective, will provide a single federal standard on proxy access to which the state law provisions of Delaware and other states will become complementary.
SECTION 11: DUTIES UNDER THE FEDERAL SECURITIES LAWS
Federal and state laws regulate the disclosure practices and securities transactions of public companies and their directors, officers, and employees. The federal securities laws are administered by the SEC and affect many daily activities of public companies. Violation of these laws may result in significant civil and criminal penalties, imposed not only on the corporation, but also potentially on individual directors and officers. Directors need to be particularly attentive to their own, as well as the corporation’s, compliance with these laws. Review of programs and policies designed to maintain compliance with the federal securities laws, absent assignment of responsibilities to a legal compliance committee, is often delegated to the audit committee.
A corporation must maintain effective systems of internal controls and procedures for collecting, reviewing, and disclosing financial and other material information about the corporation. Quarterly review and certification of the effectiveness of systems and procedures that support SEC filings are required of the CEO and the CFO of public companies. Annual evaluation of internal controls over financial reporting by management and attestation of internal controls over financial reporting by the external auditor are also required for many companies. The board, generally through its audit committee, should receive and examine reports concerning each of these reviews.
A. SEC REPORTING REQUIREMENTS
Public companies must file both periodic and current reports with the SEC. Periodic reports include an annual report on Form 10-K and quarterly reports on Form 10-Q. Current reports on Form 8-K are required for disclosure of quarterly earnings releases, material contracts, changes in the board and management, shareholder meeting voting results, and a broad spectrum of other specified events. A Form 8-K may also be used for voluntary disclosure of information. The SEC’s proxy rules require that the annual meeting proxy statement be accompanied or preceded by an annual report to shareholders. Many of these reports must include specified financial and other information.
The corporation’s annual report on Form 10-K contains the last fiscal year’s audited financial statements, as well as risk factors, management’s discussion and analysis of the corporation’s results of operation and financial condition, and important trends and uncertainties. The Form 10-K is the most detailed of the reports filed with the SEC, and it must be signed by a majority of the corporation’s directors. Separate and apart from the audit committee’s involvement, all directors should review and be satisfied with the corporate processes used to prepare the Form 10-K and understand the significant disclosures in that report. Therefore, the full board should have an opportunity to read, comment on, and ask questions about the Form 10-K before it is filed.
Directors are not expected to verify independently the accuracy of underlying facts contained in earnings releases or reports filed with the SEC, but they should be satisfied that the disclosures are not contrary to the facts as they know them. In addition, the audit committee and the board should be satisfied that there are disclosure controls and procedures in place reasonably designed to achieve the timeliness, accuracy, and completeness of annual and quarterly reports, as well as all other reports and public releases. In addition, the CEO and CFO of public companies are required to review and, based on their knowledge, certify the material accuracy and completeness of quarterly and annual reports. Quarterly assessments of disclosure controls and procedures and annual assessments of internal control over financial reporting are also required. Audit committee members of public companies should be familiar with these certifications and assessments and the procedures undertaken to support them, and the audit committee should always be attentive to reports of control deficiencies, especially material weaknesses, and be satisfied with management’s classification of items as significant deficiencies rather than as material weaknesses.
B. PROXY STATEMENTS
Public companies soliciting proxies for shareholder votes on the election of directors or other matters must furnish each shareholder with a proxy statement. In most cases, the company files only the final proxy statement, as distributed. In other cases, if actions other than election of directors or other routine business are to be taken, the company must file a preliminary proxy statement with the SEC, which will often review and clear it. Directors should be attentive to the procedures followed in preparing the corporation’s proxy statements. It is good practice for every director to review a reasonably close-to-final draft of the proxy statement before it is distributed or filed with the SEC, particularly sections dealing with matters about which the director has personal knowledge or containing a report of a committee on which the director serves. Similar disclosure requirements can apply when corporate action is being taken without soliciting proxies.
The proxy statement for the annual shareholder meeting must include information about the company’s directors, officers, and principal shareholders, as well as about certain of its governance policies. With respect to directors in particular, the proxy statement must include disclosure about each director’s and director nominee’s experience, qualifications, attributes, or skills that led the board to conclude that the person should serve as a director of the company as of the time the proxy statement is filed with the SEC. It must also include extensive information about the company’s compensation of its officers and directors, both in tabular and narrative form, including a detailed discussion of the company’s compensation objectives, policies, and practices, as well as information about related person transactions.
C. FAIR DISCLOSURE
The SEC’s Regulation FD (for “fair disclosure”) provides that material information about a public company may not be disclosed on a selective basis by the corporation or its agents to marketplace participants, such as analysts, brokers, investment advisors, and shareholders who may act on the information and have not agreed to keep the information confidential. Rather, the corporation must take steps to disseminate such information in a manner that makes it broadly available to all market participants simultaneously. As a result, directors should be careful not to disclose non-public information about the corporation and its business. Violations of Regulation FD have resulted in SEC enforcement actions and fines against public companies and corporate officers. Regulation FD has caused public companies to adopt more restrictive policies regarding the persons authorized to speak on behalf of the company with securities analysts and others. It has also prompted many companies to make more information public.
D. REGISTRATION STATEMENTS
Directors should take diligent steps to assure the accuracy of their corporation’s registration statements filed with the SEC in connection with any offering (including in a merger or acquisition) of the corporation’s securities to the public. Regardless of whether a director actually signs the registration statement, the director is liable for any material inaccuracy or omission in the registration statement, including information incorporated by reference from other filed documents, unless the director establishes that, after due diligence, the director was not aware of the inaccuracy or omission.
The director’s primary defense to registration statement liability is due diligence. To establish this defense, the director must show that, after reasonable investigation, the director had reasonable grounds to believe and did believe that the registration statement did not contain any materially false or misleading statements or any material omissions that made the registration statement misleading. Actions required by the director to satisfy the due diligence standard will vary with the circumstances. During the registration process, directors should satisfy themselves that the corporation has developed and used appropriate corporate disclosure controls and procedures reasonably designed to ensure the registration statement’s accuracy and completeness. Although all registration statements should be prepared with appropriate care, certain registered offerings may have a higher potential for liability, such as an initial public offering, a follow-on equity offering, a large acquisition using the corporation’s equity, or a financing or reorganization of a public company that has experienced problems. Accordingly, a board meeting or meetings with counsel, accountants, and management present at which there is discussion and analysis of the disclosures in the registration statement should precede the filing of registration statements for such offerings.
For many companies, the disclosures in the company’s Form 10-K and other reports filed previously with the SEC are incorporated into the registration statement. Therefore, the procedures used to review these reports are important when there is a registered securities offering. Each director also should personally review the registration statement for accuracy, with particular attention to those statements and disclosures in the registration statement that are within the director’s knowledge and competence. Directors may also want to consider consulting with the corporation’s legal counsel to understand any material changes made to disclosure documents in response to SEC comments and to confirm that the process followed is intended to fulfill the due diligence requirements.
E. INSIDER TRADING
The federal securities laws prohibit corporate insiders, including directors, and the corporation itself from purchasing or selling securities, either in the open market or in private transactions, when they possess non-public, material information about the corporation. The corporation or an insider in possession of such information may not take actions involving the securities until the information is publicly disseminated. Policies should be adopted to address securities transactions, including transactions in 401(k) plans and gifts of securities. The federal securities laws also prohibit insiders from revealing material, non-public information concerning the corporation, or giving a recommendation to buy or sell based upon such information, to others who trade based upon such information. Under the SEC’s Rule 10b5-1, directors and other insiders can mitigate the risk of insider trading liability by adopting plans in advance for scheduled sales and purchases of the corporation’s securities. As a general rule, the federal securities laws also prohibit the recipient of a tip from acting on material, non-public information obtained from a corporate source.
Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy, sell, or hold a security. Some believe that information may be considered material if, upon disclosure, it would likely affect the stock price. If there is any doubt whether undisclosed information is material, legal guidance should be sought or, as a practical alternative, the information should be treated as material.
Violation of any of these insider trading laws triggers strict sanctions. The violator is liable for any profit made or loss avoided. In addition, a court can assess a penalty against the trader, the tipper, or the tippee of treble damages—that is, three times the profits made or losses avoided. Criminal sanctions are also possible. The SEC has an aggressive program of discovering and proceeding against insider trading violations. It can award informants who report a violation a percentage of the amount of the penalty recovered. The SEC also can prohibit any individual from serving as an officer or director of any public company if the individual has violated the antifraud or insider trading laws and demonstrates unfitness to serve as an officer or director. In addition to potential violations of federal law, the misuse of confidential corporate information can result in violations of directors’ duties under state law, leading to civil lawsuits brought by shareholders.
Many public companies have procedures requiring senior executives and directors to contact corporate counsel, the corporate secretary, or another designated person before trading in the corporation’s securities so that any proposed transaction can be reviewed in the light of the current state of public information. Many public companies have policies prohibiting insiders and their affiliates from trading in the corporation’s securities during specified “blackout” periods. The board of directors (directly or through its audit or legal compliance committee) should periodically review corporate information disclosure and insider trading policies and procedures in view of Regulation FD (discussed above) and insider trading prohibitions.
F. REPORTING SHARE OWNERSHIP AND TRANSACTIONS; SHORT-SWING PROFITS
Directors, executive officers, and large shareholders of public companies must report to the SEC all their holdings of and transactions in the corporation’s equity securities and must disgorge to the corporation any profits realized from buying and selling (or selling and buying) such securities within any six-month period. Any person who becomes an insider (e.g., a director, executive officer, or more than 10 percent shareholder) is required to file a report of beneficial ownership and must do so whenever there is a change in beneficial ownership. These reports must be filed on a timely basis. All delinquent filings must be disclosed in the corporation’s annual meeting proxy statement (with the delinquent individuals identified by name), and they can trigger monetary fines. An insider is generally deemed to be the owner of securities that are owned by a spouse or child living with the insider, and may also be deemed to be the owner of securities held in a trust of which the insider is a trustee, settlor, or beneficiary, or of securities owned by a corporation or other entity controlled by the insider.
Profit disgorgement is required if an insider purchases and sells the corporation’s securities within a six-month period and vice versa (i.e., sells within six months before buying). Any “profit”—measured as the difference between the prices of any two “matchable” transactions during the six-month period (i.e., the highest priced sale and the lowest priced purchase)—must be paid to the corporation. The requirement is intentionally arbitrary and, subject to tightly defined regulatory exemptions, applies to all transactions within any six-month period regardless of whether the insider had inside information or, in fact, made a profit on an overall basis. This provision is aggressively enforced by a plaintiffs’ bar that monitors SEC filings.
Some transactions, such as the grant and exercise of stock options and the acquisition of securities under employee benefit plans, may be exempt from the purchase and sale triggers of the short-swing profit rules if procedural requirements established by SEC rules have been satisfied. Absent an exemption, the receipt of an option, the acquisition of securities through a benefit plan, or the acquisition of a derivative security related to the value of the corporation’s common stock normally will be considered to be a purchase of the underlying security and could be matchable against a sale. Unexpected liability may result from the application of the short-swing profit rules. For example, other indirect changes in ownership, such as reclassifications, intra-company transactions, pledges, and mergers, may be considered a purchase or sale transaction for purposes of the short-swing profit rules.
A retiring director may be subject to profit recovery based on transactions occurring during the six months after the director departs. If a director purchases shares of the corporation, resigns, and sells shares within six months after the purchase, liability may be imposed for any short-swing profit even though the individual is no longer a director at the time of the sale.
Directors, officers, and more than 10 percent shareholders also are prohibited from selling the corporation’s shares short; as a means to enforce this restriction, they are required to deliver shares against a sale within twenty days.
This regulatory regime is highly technical. Legal counsel should be consulted before committing to a transaction in the corporation’s securities or in options or other derivatives geared to its securities.
G. SALES BY CONTROLLING PERSONS
Unless an exemption is available, the federal securities laws generally require registration with the SEC of the corporation’s securities before those securities can be offered or sold to the public by “controlling persons.” (Determining who is a controlling person is a complex question of law and fact for which legal guidance is advisable; directors are often considered to be “controlling persons.”) The most common exemption is provided by the SEC’s Rule 144, which permits the sale of limited amounts of securities without registration if certain conditions are satisfied. Securities acquired by a controlling person in the open market or in a registered offering are subject to the conditions in this rule, which include special filing and disclosure requirements, if they are to be sold to the public.
H. COMPLIANCE PROGRAMS
Many public companies have established specific policies and procedures dealing with public communications, share ownership reporting, and insider trading. These programs are designed to ensure that the corporation makes complete, accurate, and timely disclosure of material information, complies with the registration requirements, and satisfies other securities law obligations. These programs also help directors and other insiders to comply with insider trading and other applicable laws and the corporation to meet its obligations under Regulation FD to avoid improper selective disclosure of material information. The audit committee (or the legal compliance committee, if there is one) generally should monitor the establishment and operation of such compliance programs.
I. DIRECTORS OF FOREIGN CORPORATIONS WITH SECURITIES TRADED IN THE UNITED STATES
A large number of non-U.S. corporations file reports with the SEC because their securities are traded on U.S. securities markets or they have a large number of U.S. holders. Traditionally, the federal securities laws have required these “foreign private issuers” to file annual reports and other material information distributed to their shareholders with the SEC but have not otherwise sought to regulate their corporate governance and other internal practices.
The Sarbanes-Oxley Act’s reporting and corporate governance requirements generally apply to non-U.S. corporations that have securities registered with the SEC. The SEC, in adopting rules under the Sarbanes-Oxley Act, has considered the concerns of foreign private issuers and made some rules inapplicable to them or included special provisions addressing their concerns. Directors of foreign private issuers should be aware of the general categories of substantive corporate governance requirements that may apply to their corporations.
SECTION 12: LIABILITIES, INDEMNIFICATION, AND INSURANCE
Directors may incur personal liability for breaches of their duty of care or their duty of loyalty or for failure to satisfy other legal or regulatory requirements, such as the federal securities laws. Corporations may provide for certain limitations on these liabilities, and may also provide directors (and officers) with indemnification rights and insurance. Such provisions allow directors to focus on the creation of value without undue personal risk. Directors should review periodically a corporation’s indemnification and insurance as applicable to both directors and officers, in order to ensure that proper consideration has been given to those important issues.
A. SOURCES OF LIABILITY
1. Corporate Law Liability
Corporate law generally provides that directors are fiduciaries and therefore have both a duty of care and a duty of loyalty. Directors may in theory be liable for violating either of those duties, but nearly every public, and most private, corporations formed in U.S. jurisdictions have, through their charters, precluded monetary liability for directors who breach only the duty of care. Directors should consider whether corporations on whose boards they serve have eliminated such liability.
Directors in most jurisdictions may, however, have monetary liability for breaching the duty of loyalty. Directors can incur liability where they have a conflicting personal interest or are dominated or controlled by a person or entity with such a conflict. Directors should be alert to such conflicts, particularly in corporations with controlling shareholders and in change-in-control transactions where courts are especially sensitive to the duty of loyalty. There are a number of techniques to address these concerns, including disclosure of potential conflicts, recusal of conflicted directors, use of independent committees, and shareholder votes. In addition to liability involving a conflict of interest, directors may also incur liability for breach of the duty of loyalty where their inattention to their duties rises to a level constituting “bad faith” or “conscious disregard for their duties.” Good recordkeeping of board procedure and deliberations is important to protecting directors from liability when, in retrospect, business decisions with poor outcomes are alleged to have resulted from conflicts or inattention.
In addition to liability for breach of duties, directors can also be personally liable for authorizing dividends or other distributions, such as stock repurchases, when a corporation is insolvent. This is an area requiring particular caution, because directors may be liable for simple negligence, a lower standard than that typically applicable to liability for breaching fiduciary duties. Accordingly, wherever there is any question as to a corporation’s solvency, directors should obtain appropriate advice before making distributions to shareholders.
2. Federal Securities Law Liability
As discussed above, directors can be personally liable under the federal securities laws—in some cases even when they act in good faith. In certain circumstances, negligence, by itself, is sufficient to establish liability. In other situations, liability may be imposed, subject only to due diligence or other defenses, without a finding of fault or intent to deceive.
3. Liability Under Other Laws
Directors also can be subject to personal liability under other state and federal statutes, such as environmental laws. Good faith and careful monitoring of management programs directed toward corporate legal compliance (including through periodic briefings on how well the programs are functioning and changes in them) should provide substantial safeguards against any such personal liability.
B. PROTECTIONS
Several mechanisms help protect directors from personal liability: charter provisions limiting liability, rights to indemnification, advancement of related expenses, and insurance.
1. Limitation of Liability
Most state corporation statutes permit a corporation’s charter to include a provision eliminating or limiting the liability of directors to the corporation and its shareholders for monetary damages for breaches of certain duties. The provisions will most frequently eliminate exposure to claims requesting monetary damages for breaches of the duty of care. They do not, however, cover claims for injunctive relief or liabilities to third parties, and they may not be effective to protect a director from liabilities resulting from federal law violations. Generally, these provisions do not protect directors from monetary liability for illegal dividends or stock repurchases, for bad faith actions, for breach of the duty of loyalty, for intentional violations of law or actions where the director received an improper benefit.
2. Indemnification
Most state corporation statutes specify the circumstances in which the corporation is permitted to indemnify directors against liability and to pay related reasonable expenses incurred in defending claims arising in connection with their service as directors.
In general, directors must meet a certain standard of conduct before being indemnified. The standard for permissible indemnification in many state statutes is that the individual director must have acted in good faith and with a reasonable belief that the director’s conduct was in (or not opposed to) the best interests of the corporation. In the case of criminal proceedings, the director must also have had no reasonable cause to believe the conduct was unlawful. Such statutes give corporations the power to indemnify directors in actions by third parties, including class actions, for expenses (including attorneys’ fees), judgments, fines, and amounts paid in settlement of the actions. In some instances, however, indemnification is not permitted, regardless of the director’s standard of conduct. For example, many jurisdictions prohibit indemnification for actual liability in derivative actions.
3. Advancement
In addition to permitting indemnification, state corporation statutes authorize corporations to advance legal fees. For the most part, the limitations on actual indemnification do not apply to advances of legal expenses. Instead, corporate statutes generally permit a corporation to pay a director’s legal expenses during the pendency of almost any lawsuit. A director benefiting from such an advance, however, must promise to repay the advance if it is ultimately determined that the director is not entitled to indemnification. The cost of defending a claim can be substantial, making advancement of expenses important.
4. Mandatory Indemnification and Advancement
State law generally provides corporations with broad discretion to make indemnification and advancement payments, but it provides directors with only limited rights to receive those payments on a mandatory basis. For example, many state statutes provide that indemnification for legal expenses is mandatory when the director has been successful in defending a suit. In order to induce directors to serve, most corporations provide for mandatory indemnification and advancement under certain additional circumstances through provisions in their charters or bylaws or through separate agreements with directors. In many instances, these provisions provide that directors are to be indemnified and advanced expenses to the fullest extent permitted by law. In other cases, the indemnification rights are more limited. Directors should understand the extent of their mandatory rights and any limits on those rights.
5. Insurance
Most corporations purchase directors’ and officers’ liability insurance covering (i) the corporation for any payment of indemnification and advances for expenses and (ii) directors and officers, if the corporation is unwilling to pay indemnification or advancement obligations (perhaps because of a change in control) or is unable to pay such obligations (perhaps because of insolvency or because the claim is one where indemnification or advancement is not permitted). The relevant statutes of most jurisdictions permit the corporation to pay premiums for this insurance. Because of uncertainty regarding the ability of directors and officers to access policies that also cover the corporation, corporations should consider policies that cover only non-management directors. Such policies often include terms more favorable to the insured than policies that cover both the corporation and its directors.
Certain areas of activity such as environmental, employee benefit, or antitrust matters are often excluded from coverage under a typical directors’ and officers’ policy. Coverage may also exclude conditions in existence at the time of the application for insurance. Directors’ and officers’ insurance generally does not cover fraud, criminal penalties, and fines and sometimes excludes punitive damages.
Insurance coverage is not available in every case. Most policies are written on a “claims made” (as compared to an “occurrence”) basis, covering only defined claims lodged against directors during a specified period. In addition, the terms of coverage under differing policies are very complex and can vary greatly from insurer to insurer. Moreover, insurance markets change rapidly, and insurers may assert numerous reservations or defenses when claims are made. Therefore, directors are well advised to engage experts, who can also provide knowledgeable insight respecting current market conditions.
In short, it is important for directors to understand the types of directors’ and officers’ insurance a company has, in addition to the amount of coverage. Directors should ascertain the level of expertise of the person within the corporation responsible for negotiating the coverage or, in the alternative, determine whether an outside expert, familiar with current market conditions and policy and claim issues, is assisting in the process. Directors should also take care (as is true in the case of any insurance policy) in completing policy applications and questionnaires and inquire about the insurance provider’s reputation for handling insurance claims and its financial strength. This consideration can be more important than premium pricing. Disputes with the insurance carrier as to whether coverage is available when litigation materializes are an unwanted distraction. Directors’ and officers’ insurance is a complex area, and directors should seek assurance that the corporation’s coverage does in fact afford the best protection obtainable in the current marketplace.
Arthur and Toni Rembe Rock Center for Corporate Governance, Stanford Law School
The center creates a cross–disciplinary environment where economists, lawyers, financial experts, political scientists, engineers, and practitioners can meet and work together to advance the practice and study of corporate governance.
Carol and Lawrence Zicklin Center for Business Ethics Research, The Wharton School of the University of Pennsylvania
A center for business ethics teaching and research at The Wharton School. The center’s website lists its publications, upcoming conferences, and links to online business ethics, corporate governance, and compliance resources.
Center for Leadership and Change Management, The Wharton School of the University of Pennsylvania
The center conducts research and determines practical application in the area of leadership and change, fosters an understanding of how to develop organizational leadership, and supports global leadership initiatives. Its website has links to corporate governance publications and online resources.
Corporate Law Center, University of Cincinnati College of Law
The University of Cincinnati College of Law’s center focuses on issues of importance to corporate lawyers and administers the Securities Lawyer’s Deskbook. The center also conducts an annual corporate law symposium.
The center is a nonprofit research organization dedicated to advancing high ethical standards and practices in public and private institutions. It provides many services to businesses including assistance in establishing an effective ethics and compliance program.
Institute for Business and Professional Ethics, DePaul University
An institute at DePaul University that promotes ethical decision-making in business. The institute’s website provides information on upcoming events and links to other resources on the web.
Kennesaw State University Corporate Governance Center
The website of the center contains an extensive list of periodicals and websites related to corporate governance, and the center provides various board advisory services.
John L. Weinberg Center for Corporate Governance, University of Delaware
The center proposes progressive changes in corporate structure and management through education and interaction. It conducts conferences, workshops, research, publication, and other activities to create a forum for business leaders, members of corporate boards, the legal community, academics, practitioners, and students interested in corporate governance issues.
Millstein Center for Corporate Governance and Performance, Yale University
This center at the Yale School of Management provides active support for research in corporate governance and disseminates its work to the world’s academic, policy-making, and professional communities.
The Pension Research Council of the Wharton School of the University of Pennsylvania
The Pension Research Council is an organization devoted to generating and enhancing the debate on policy issues affecting pensions and other employee benefits.
A membership section of the American Bar Association furthering the development and improvement of business law, educating members in business law and related professional responsibilities, and helping members to serve their clients competently, efficiently, and professionally. The Section of Business Law includes the following:
Committee on Corporate Governance
Corporate Laws Committee
Committee on Federal Regulation of Securities
Presidential Task Force on Corporate Responsibility
A membership organization of in-house counsel whose members represent attorneys employed by more than 10,000 legal departments of corporations, associations, and other private-sector organizations in seventy countries.
An organization of more than 150 CEOs of America’s largest companies that calls for a focus on “substance over form,” rejecting a call by some institutional investors for such fixed policies as mandatory retirement ages for directors, outside directors that are completely independent of management, and separation of the roles of CEO and board chair.
A business membership and research organization whose membership includes over 2,900 companies in 65 countries. The Conference Board conducts a wide range of conferences and produces a variety of publications. The organization has a governance center, the website of which includes a blog providing timely analysis of corporate governance issues and resources for boards.
A membership organization for board members and advisors. The NACD publishes a variety of reports on corporate governance, as well as a monthly newsletter.
An association with 6,000 members whose purposes is to meet the needs of stock plan professionals whose responsibilities relate to stock plan design and administration, including compensation and human resources professionals, stock plan administrators, securities and tax attorneys, accountants, compensation consultants, corporate secretaries, transfer agents, stock brokers, and software vendors.
An association of over 4,000 corporate officers and investor relations consultants from 2,000 public companies. The institute produces a monthly newsletter and quarterly magazine, as well as conducts a variety of seminars and conferences every year.
A membership organization designed “to develop sustainable business strategies and solutions” in the areas of the environment, human rights, economic development, and governance and accountability.
An international group of business leaders that promotes moral capitalism using sustainable and socially responsible business practices. The CRT’s Principles of Business is available online in twelve different languages.
Six indexes that track the financial performance of the leading sustainabilitydriven companies, with the global index covering the top 10 percent of the biggest 2,500 companies in the world.
The center has 275 faith-based institutional investor members, including national denominations, religious communities, pension funds, foundations, hospital corporations, asset management companies, colleges, and unions, and seeks to integrate social values into corporate and investor actions. The website lists and has links to shareholder proposals submitted for annual meetings.
The Social Investment Forum is a membership organization for professionals, firms, institutions, and organizations that advances socially responsible and sustainable investing.
California Public Employees’ Retirement System (CalPERS)
The California Public Employees’ Retirement System is the nation’s largest public pension fund. The website includes links to the websites of approximately forty other public pension systems.
This is a nonprofit association organization of over 140 large public, union, and corporate pension funds. The council advises its institutional shareholder members about corporate governance, shareowner rights, and other investment issues to help them protect pension plan assets and seeks to be a prominent voice for institutional shareholder interests.
The Investment Company Institute is a national association of investment companies, and its membership includes over 7,000 mutual funds. The institute encourages adherence to high ethical standards; advances the interests of funds, their shareholders, directors, and investment advisors; and promotes public understanding of mutual funds and other investment companies.
Teachers Insurance and Annuity Association—College Retirement Equities Fund (TIAA-CREF)
TIAA-CREF is the nation’s largest retirement system, with over 2 million members from academic, medical, cultural, and research institutions. It provides its members with financial products and services and monitors corporate governance policies to protect its members’ retirement assets.
The association is an independent, non-profit membership organization dedicated to working with investors, companies, and regulators to implement effective corporate governance practices throughout Asia.
British Accounting Association: Special Interest Group on Corporate Governance, Cardiff Business School
The group’s purpose is to serve as a forum for research and dialogue on corporate governance issues and to bring together academics and professionals to discuss their research and the latest developments in international corporate governance.
The Coalition was formed to promote good governance practices in companies owned by its members. Generally, these companies are members of the S&P/TSX Composite Index. The Coalition’s members are institutional investors: pension funds, mutual funds, and third party money managers (currently forty-one members managing over $1.4 trillion in assets).
The institute researches all aspects of Canadian corporate governance to help Canadians become informed about the laws, regulations, economic issues, and policy debates surrounding corporate governance. It studies governance of listed corporations, family firms, public sector enterprises, and not-for-profit organizations.
Centre for Corporate Governance Research, Birmingham Business School
The centre researches the relationship among directors, investors, and other stakeholders, voting trends, and other corporate governance developments in the United Kingdom and internationally.
Clarkson Centre for Business Ethics & Board Effectiveness
The CCBE is located at the Rotman School of Management at the University of Toronto. It monitors Canadian corporate governance trends and provides guidance to firms looking to improve their board effectiveness and disclosure.
European Commission: Modernization of Company Law and Enhancement of Corporate Governance
The communication explains why the European regulatory framework for company law and corporate governance needs to be modernized and proposes several initiatives to achieve this modernization.
The institute is an international scientific non-profit association that provides a forum for debate and dialogue between academics, legislators, and practitioners, focusing on major corporate governance issues and best practices. The institute’s website includes links to corporate governance laws and regulations for numerous countries.
The forum is a joint project between World Bank and Organisation for Economic Co-operation and Development and supports regional and local initiatives to improve corporate governance in middle- and low-income countries in the context of broader national or regional economic reform programs.
Hermes is a UK-based organization that provides asset and pension fund management services and advises on responsible investing. Its website discloses its pension fund voting history.
An organization to support and educate chartered secretaries in Hong Kong companies on corporate governance, compliance, and other legal developments related to chartered secretaries’ responsibilities.
Institute for International Corporate Governance and Accountability
The institute studies corporate governance systems and capital markets throughout the world and develops methods to devise and sustain responsible and accountable corporate behavior.
The mission of this institute is to represent the interests of directors—to foster ex-cellence in directors to strengthen the governance and performance of Canadian corporations.
An organization of about 45,000 directors in the United Kingdom that provides its members with information on local and international corporate governance members and best practices related to their duties and responsibilities as directors.
The institute is committed to the development of directors, continuous board learning, and improving board effectiveness by providing members ongoing educational opportunities, technical advice, and leadership publications and updates featuring the latest developments in corporate governance, as well as unique net-working opportunities.
International Association for Business and Society
An association composed of academics and practitioners that researches relationships between business, government, and society. The association’s website contains information on upcoming conferences, links to its Business and Society journal, and copies of its newsletter.
The network is a global membership organization of around 450 leaders in corporate governance based in forty-five countries with a mission to raise standards of corporate governance worldwide.
Organisation for Economic Co-operation and Development
The organization provides a setting where governments compare policy experiences, seek answers to common problems, identify good practice, and coordinate domestic and international policies. Thirty-three countries are members of the organization.
Proxinvest is an independent French proxy voting advisory company that provides services exclusively to investors, large and small, using methods that promote shareholder interests.
SHARE is a Canadian proxy advisory firm focused on environmental, social, and governance issues. It makes research, including with respect to shareholder proposals, available on its website.
Social Investment Organization: The Canadian Association for Socially Responsible Investment
A nonprofit membership organization composed of financial institutions, investment firms, financial advisors, and other organizations and individuals interested in socially responsible investment in Canada.
United Kingdom Institute of Chartered Secretaries and Administrators
The institute is the international qualifying and membership body for the chartered secretary profession. Its members help shape the governance agenda and promote the best practices essential for organizational performance.
The institute is a non-party political business organization with around 55,000 members, including directors from many sectors of the economy—from media to manufacturing, e-business to public sector—and CEOs of large corporations and entrepreneurial directors of start-up companies.
Business lawyers must be flexible and advise their clients on a plethora of legal issues. Clients expect them to not only provide accurate legal advice, but to also provide it in a practical and digestible form. Often, particularly given the fast pace of business today, business lawyers are in the unenviable position of being forced to give a kind of template for how a situation should be resolved.
This is understandable, because their clients must make many decisions. It is not always possible to stop the flow of business and to seek legal advice on every point. Yet actions the client may take can have enormous implications for overall liability, as well as particular employment law and tax implications both immediately and for many years into the future.
The decision whether to hire a worker as an employee or an independent contractor is a significant one with fingers in a large number of pies, with regulations from the IRS, the Department of Labor and employment statutes, and state unemployment insurance authorities. In fact, it is hard to think of a more consequential business decision. Yet paradoxically, the question whether to hire someone in one capacity or the other may garner little attention from business people.
Because of the potential for staggering tax and other liabilities such decisions can trigger, business lawyers must be vigilant. Far from being a one-time or immediate problem, the issue has significant legal implications down the road. When a business client hires workers in any capacity, they understandably focus on business objectives. Whether or not the arrangement works out well, clients tend not to revisit fundamental questions such as whether the workers should be independent contractors or employees.
Businesses can avoid major landmines if they consider these topics from time to time. Business lawyers can serve a key function in this regard. Business lawyers should encourage their clients do so when additional workers are brought on, when the tenure and nature of the relationship changes, when the tasks expected of the worker expand or contract, or when other terms and conditions of the work change. The worker’s role may morph into something quite different from what it was at the inception of the relationship. That can impact the status of the worker as an employee or independent contractor.
Here are the top 10 mistakes I see committed by companies in using workers the company may believe are safely independent contractors but who may actually turn out to be reclassified as employees.
1. Not Having a Written Contract
Failing to have any written agreement for independent contractors is a recipe for disaster. If you hire a plumber for a one-time toilet fix and pay out $200, I would not worry that he or she is an employee. Yet it is surprising how many businesses have regular and long-term workers-on their premises or off-paid month after month and year after year as independent contractors without a written contract.
As a business lawyer, if you become aware of such a situation, take steps to warn your client. Without a written contract, your client is virtually doomed to fail in any dispute over the status of the worker, no matter how strong the client’s independent-contractor facts may be.
The taxing, labor and employment, and insurance authorities expect a written contract that states that the worker is an independent contractor and will be paid as such with no tax withholding, no benefits, etc. See Illinois Tri-Seal Prods., Inc. v. United States, 353 F.2d 216, 218 (1965). Plainly, such a contract does not by itself mean the worker is really an independent contractor, but the lack of a written contract will make employee status much more likely.
Furthermore, your client may even have a dispute with the worker directly. If the worker later claims that he or she considered him or herself to be an employee, to what will your client point as a contrary indication?
2. Treating Similar Workers Differently
Many businesses have some employees and some independent contractors, and there is nothing improper in so doing. However, it is inappropriate to have to have one worker selling shoes on an independent-contractor basis and another similarly situated worker doing the same thing as an employee. The same can be said for having some employee messengers and some independent-contractor messengers (or sales people, computer programmers, or what have you).
The risk of treating similarly situated workers differently is that the workers you are trying to treat as independent contractors may be reclassified as employees. For example, in Institute for Resource Management Inc. v. United States, 22 Cl. Ct. 114 (1990), no safe harbor was available for employment tax treatment of any worker who was treated as an independent contractor if the business treated any worker holding a substantially similar position as an employee for employment tax purposes. In other words, you set yourself up for trouble by having the two differently classified workers for ready comparison by the IRS, state tax authorities, labor or employment agency, or other authority. They all look for this tell-tale sign.
Advising a client in this area requires that you help the client to make significant distinctions between the two types of workers. Some companies are able to have two groups of workers do essentially the same type of work-such as independent-contractor sales agents and employee sales agents. However, business lawyers need to be very careful in helping clients navigate these waters.
3. Providing Tools and Supplies
One of the hallmarks of independent contractors is that they are required to supply their own tools, equipment, and supplies. Rev. Rul. 71-524, 1971-2 C.B. 346 ruled that a trucker working for a trucking company that leased vehicles (and provided maintenance) was an employee. See also Rev. Rul. 87-41 1987-1 C.B. 296, point 14. As with just about everything else in the contractor versus employee characterization realm, this is not dispositive by itself. However, it is certainly something reviewed in making a thumbs-up or thumbs-down decision.
After all, independent contractors are classically independent business people or professionals. It makes sense that they would bring their own ladder, shovel, or paint brush. A company that purports to have independent contractors but that supplies a desk, chair, computer, software, and telephone-everything they need-may not be very convincing in a worker status dispute. As this example suggests, this problem may be most common with office work. Still, it can arise in virtually any setting. In this age of high technology, it is not easy to determine exactly what will be regarded as tools, supplies, and equipment. The safest bet may be to make sure you don’t provide anything. But that can be impractical. (For possible ways around this conundrum, see No. 5 “Paying By the Hour” below.) As a lawyer advising in this area, get as many facts from your client as you can, and try to be creative.
4. Reimbursing Expenses
Another red flag is the extent to which your client reimburses workers for their business expenses. See Rev. Rul. 55-144, 1955-1 C.B.483, where an individual had his business expenses recouped by his auto dealership employer and was deemed to be an employee. See also Rev. Rul. 87-41, 1987-1 C.B. 296, point 13. If workers work late, does your client pay for their dinner or a taxi? If they need special paper for the report they are producing, does your client provide it or reimburse them?
There is no bright line saying one can’t cover the expenses of an independent contractor, but doing so can suggest the worker is an employee. Classically, all such items are supposed to be factored into the price you are paying the independent contractor for a finished product. As a result, reimbursements and reimbursement policies are likely to be reviewed if your client becomes involved in a worker classification dispute.
Lawyers should point out these risks to clients. Your clients might think they are being magnanimous to cover such items. The reality is that the clients may be blurring the line between the employees and independent contractors.
5. Paying By the Hour
How a business pays someone is about a fundamental a work-variable as one can get. And it can be one of the most fundamental indicators of whether a worker is an employee or an independent contractor. See Rev. Rul. 87-41, 1987-1 C.B. 296, point 12. Classically, one pays a contractor for a job, like putting a pool in your backyard, repairing your computer system, or putting in a break room at your office. In contrast, one classically pays employees by the hour or by the week.
Yet it is surprising how many businesses don’t think about this issue, much less explore ways to package it. There is no rule saying that one cannot pay an independent contractor by the hour. After all, that is how most lawyers bill time to their numerous clients.
But when one has alternatives, paying by the hour can be unwise. Consider whether you can come up with a payment regimen that fairly covers all the elements going into the work and yet that is independent contractor-like in scope. Ideally, a project fee or success fee is more consistent with independent-contractor status than an hourly rate. Help your clients to be creative in considering compensation alternatives.
Furthermore, you may be able to help your client to address any tool, equipment, and supply issues, and even expense reimbursements, as part of the payment formula you devise. As the discussion of those topics noted (see No. 3 “Providing Tools and Supplies” and No. 4 “Reimbursing Expenses” above), you don’t want to provide items that are employee-indicators. Yet if an independent-contractor worker arrives at the job site with no hammer, understandably, you may want to provide one.
The answer may be to do so but to have the business charge back the worker for the item provided. The worker could have the charge subtracted from his invoice at the end of the week. As a lawyer, you may find that a little creative thinking with independent contractors will help your clients to remain in the same place economically but with a vastly better appearance, viz., the likelihood independent-contractor treatment will be upheld.
6. Failing to Have Consistent Forms and Documents
The fact that your client calls someone an independent contractor does not make it so. An “employee lounge” sign in an office does not mean only employees can go there. The fact that one pays a worker based on a time card and then issues a check and paystub does not make him or her an employee. But all these things add up.
Sometimes, after all, something is what you call it. So help your clients consider whether they should have an “employee file” for each employee and use a different name for independent contractors. Ask your clients to consider if independent contractors should turn in an “invoice,” not a time card. Ask your clients to consider whether independent-contractor discipline should be handled in exactly the same way as employee discipline. Usually, changes in terminology or substance can be made that may not impact your client’s business but that may help your client materially to bolster independent-contractor treatment.
7. Over-Supervising
With an independent contractor, one is paying for a product or result. With an employee, one is paying for him or her to do what is asked, whatever that might be. With employees, one controls not only the nature of the work, but the method, manner, and means by which they do it. In Alford v. United States, 116 F.3d 334 (8th Cir. 1997), for example, a church pastor was ruled at the district court level to be an employee, but the ruling was reversed by the Eighth Circuit based on the lack of institutional control the national and regional churches had over the operation of his church.
This control factor is the most over-arching point in this area. It is also the most over-arching way in which clients can end up in trouble with workers they believe are independent contractors but who might be ruled otherwise. How much does your client check in with workers, monitor what they are doing, or make suggestions? How frequently must the workers check in with your client and report how and what they are doing?
Urge your clients to be very careful with supervision and control. The mere fact that an independent contractor must provide a weekly progress report on how the installation of the new laundry room in your house is going does not mean the builder is an employee. But if the report involves constant tweaking and redirecting of the effort, it might be otherwise. See Rev. Rul. 70-309, 1970-1 C.B. 199; Rev. Rul. 68-248, 1968-1 C.B. 431; Rev. Rul. 87-41, 1987-1 C.B. 296.
Note that the important inquiry is not merely whether the business is exercising control over the method, manner, and means by which the worker is doing the job. It can even be fatal if your client has the legal right to do thi–even if the client fails to exercise it. Treasury Regulation Sections 31.3121(d)-1(c)(1) and 31.3401 make clear that the common law right-to-control standard is generally controlling in these matters. For that reason, urge your clients to be careful what their contracts and other documents say about reports, supervision, and the like.
8. Requiring Set Hours
One of the classic signs of employee status is a time clock or set office hours. In contrast, with independent contractors, one should normally pay for the result, not exactly when or how the worker does it. See Rev. Rul. 87-41, 1987-1 C.B. 296, points 7-8. That does not mean an employer cannot have some control over the hours an independent contractor works.
For example, the fact that you tell your building contractor not to work on your kitchen remodel past 7:00 p.m. does not make him or her an employee. Nevertheless, it is surprising how many businesses fail to consider which workers need to be on a set schedule and which workers do not. Lawyers can be good issue spotters, and should help the client to consider whether certain workers can be allowed to complete work on their own schedule as long as they meet applicable deadlines. Such flexibility can help to show that the workers involved are independent contractors. Conversely, it can be telling if your client dictates a 9 to 5 and fulltime schedule.
9. Prohibiting Competition
Many businesses using independent contractors require full-time work, prohibit competition, or both. Neither of these points alone is likely to be dispositive of an independent contractor versus employee characterization battle. They are merely factors in the determination. For example, an anesthesiologist who entered into contracts with hospitals guaranteeing to have anesthesia services available at any time (a marker of employee status) was deemed to be an independent contractor (see Rev. Rul. 57-380, 1957-2 C.B. 634, Rev. Rul. 87-41, 1987-1 C.B. 296, point 17).
For that reason, lawyers should urge business clients to consider whether the business needs such rules and why. Optimally, if your client is paying for a particular result-such as selling a minimum dollar volume of goods each month-the client should stick to that target. Point out to the client that it may be inappropriate to focus on how long the worker may take to do it or where else they may work during the same period. Those details are arguably irrelevant.
Since requiring full-time work and/or no competition will be viewed as more employee-like in nature, ask your clients to consider whether it is a good idea to dictate these terms. Always bear in mind the paradigm case: an independent contractor like a lawyer or plumber serving many clients or customers. If your clients are worried about the worker giving away the company’s business methods or intellectual property to a competitor, make those concerns explicit. Focus on prohibiting the worker from disclosing the company’s property. That may accomplish the client’s major goal and may be cosmetically much more pleasing.
10. Attempting the Impossible
As a lawyer, it is never easy to be the bearer of bad news. Yet failing to point out obviously flaws in the client’s operations or documents can be a mistake and can even result in malpractice liability. If your clients cannot possibly keep their influence and direction over workers to a minimum, cannot possibly let them come and go as they please, cannot allow them to work part-time and for other companies, and can’t abide the thought that they may make some of their own decisions, is it realistic for your clients to even try to treat them as independent contractors?
Probably not. In that situation, even if you urge your clients to apply some of the points noted here, the clients may be asking for trouble-either immediately or down the road-if they do not admit face facts.
That may mean simply treating the workers as employees. Sometimes cutting corners ends up costing the business considerably more money in the long run than if appropriate actions were taken in the first place. This occurs over and over with independent-contractor issues. Lawyers are uniquely qualified to offer such perspectives.
As an alternative to a wholesale reclassification, the business could apply this principle in stages, such as by focusing on particular types of workers or even time periods. Lawyers can help business clients engage in a kind of triage to help limit their exposure. Plainly, it is technically wrong to suggest that all short-term workers are independent contractors.
However, a business could try independent-contractor status for short-term workers and those it is trying to evaluate. If the business tries working with someone on an independent-contractor basis for three months as a kind of evaluation period, that might keep them out of company health plans, payroll processing and employment tax returns, and even worker’s compensation and unemployment insurance rolls.
If the worker settles in well, the company could bite the bullet and treat them as employees. If the worker fails, the company could assume that even if the person is later recharacterized as an employee, the company’s financial exposure should be fairly limited. For example, if your client “fires” such a worker after two months, will he qualify for unemployment benefits?
The object of this kind of approach is to limit the business client’s exposure. At least the big picture would be better because the company’s long-term workers would be employees. Even if the company ends up losing a worker-status dispute later, the employment tax or other liabilities for short-term workers should be fairly limited. In contrast, if the company is aggressive with widespread independent-contractor treatment and fails to take some of the steps I advocate here, the company could have staggering liabilities.
Conclusion
Business lawyers must often wear multiple hats, and this may particularly be true in such fundamental legal issues as worker status. Yet the role of the lawyer in helping clients through these circumstances should not be underestimated. Help your clients to evaluate what you are trying to do, what is realistic to expect, and whether your clients are being reasonable.
Moreover, urge your clients not to make this a static or one-time process. Like an annual medical checkup or annual visit with an estate planning lawyer over the terms of a will, companies and their counsel should periodically evaluate workers, their status, duties, and treatment. The more frequently companies do it the less likely it will be that they have major problems to address. As a lawyer, you should be suggesting these evaluations even if your clients are not volunteering. The optimum time for evaluations and for addressing these worker status issues is before there is a lawsuit, audit, or investigation. Don’t wait.
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