Board practices, from IPOs to director liability

The line distinguishing between business judgment and breach of fiduciary duty can be hard to identify

By Stephen M. Honig
BridgeTower Media Newswires
BOSTON, MA — There is never a dearth of interesting information concerning boards of directors — who should serve, whom do they serve, and what is the best way to sue them when you think they have messed up. So-called expert advice comes at us from every direction.

Below are some insights culled from the plethora of recent commentary.


Boards and IPOs

You are an emerging company. You need capital and you decide to go public. What should your board of directors look like?

The answers were easy before the Securities and Exchange Commission liberalized regulation of private capital formation, before SPACs, and before growing social awareness of the power of major corporations to substantially impact the lives of everyone, directly or indirectly.

A company’s founder and CFO would remain on the board, and the underwriter would name a delegate and identify someone with domain expertise and a chairman who could act as CEO if the founder was found lacking in skills at running a public enterprise.

Today, SPACs have overtaken IPOs as the primary road to public ownership (although recently the SEC expressed concern that public investors are not well-served, that SPAC disclosures are not robust, and that warrants to the promoters are liabilities and not securities).

Further, changes in SEC regulation have opened private capital to ever wider investment in emerging companies without triggering either the registration requirements of the ’33 Act or the reporting requirements of the ’34 Act.

Constructing boards for SPACs or for a private company may not require the same people as an IPO board, however. With the new federal administration’s pressure on SPACs, attention is again being directed to IPOs and thus to building the IPO board, as witnessed by a survey in the May/June issue of “Directorship,” the publication of the National Association of Corporate Directors.

Among NACD recommendations: Start building early so your board is in place a year ahead of an IPO; although pre-IPO boards ought to be small and flexible and adding too many senior directors pre-IPO may prove mechanically difficult (in getting meetings together), directors should at the least be identified if not already seated; find an experienced financial person to chair the complex SEC audit committee obligations; find a chair with public company experience; these days, finding someone with supply chain experience may be helpful; seek candidates beyond recommendations from VC investors and pay attention to diversity (as most VCs are white males lacking DEI skills).

Strangely absent from the NACD list: There is no mention of adding a person with domain expertise in the company business, and there is only passing mention of the risk of being an IPO director, arising from allegations of material misstatements or omissions in IPO disclosures.


So now you are public

There are two current trends affecting board service: enforcement of board supervisor duties, and emphasis on environmental matters. Compliance is enforced through proxy rules, general SEC disclosure requirements, proxy advisor scrutiny, public market valuation pressures, and that ultimate arbiter of board correctness — the lawsuit.

For years, I have been mentioning that there is in Delaware jurisprudence a sleeping giant: the Caremark decision (Delaware Chancery, 1996), which held that directors have a duty to supervise all functions of a corporation’s operations, and that failure to do so breaches fiduciary duty. This doctrine almost, but not quite, weakened the “business judgment rule” that protects from suit, when things go awry, directors with ordinary skills applying ordinary diligence.

The line distinguishing between business judgment and breach of fiduciary duty can be hard to identify. For years, there were few cases wherein courts found that the directors had violated Caremark, even in the face of grievous corporate gaffes. Because of this lack of litigation success, the number of such lawsuits seemed to fall.

But over time, cases did arise as the Caremark standard is so attractive to lawyers representing stockholders: Bad things happened to the company while you were a director so you must have been asleep at the switch.

Last year, in one notable case, the board of an ice cream company was found liable, per a Delaware Supreme Court decision, for safety laxity resulting in food poisoning causing three deaths (Blue Bell Creamery).

With this as background, we address current litigation against the Boeing directors arising out of crashes of 737 model aircraft that resulted in hundreds of deaths and billions in losses.

In June, Chancery heard arguments in shareholder litigation brought against directors and management, pleaded under the Caremark theory. The vice chancellor addressed claims made by asking defense: “Do you think Delaware law contemplates gross negligence claims for officer inaction, or does officer inaction have to rise to the level of bad faith?”

Faced with the allegation that directors believed that safety was “something for other people to worry about” before airplanes started falling from the sky, the defense argued that “boards are entitled to rely on members of management right up to the point where they have reasons to doubt the information provided.”

The Boeing board maintained no specific oversight over air safety, relying on multiple levels of management. Were there “red flags” that should have awakened the directors?  Should the audit committee, dealing with risk, have raised the issue?

The case was taken under advisement, but the defense argument — that boards owed no proactive function until they had reason to doubt management efforts — understates the theory of Caremark, which asserts a duty of loyalty requiring monitoring of risks even absent red flags or catastrophe.

With Boeing in mind, let us take a look at everyone’s favorite board topic these days: the “E” in ESG. Boards today had better address environmental issues for a wide variety of reasons.

First, there is Caremark. There surely are numerous red flags about the impact of extreme weather on the businesses of every corporation. All you have to do is read the press.

Environmental risk from extreme weather blatantly impacts employee safety, supply chains, consumer awareness, brand risk, market valuation and the bottom line. A wakeup call for the pervasiveness of public interest in the environment occurred last proxy season when three activist directors were elected to the ExxonMobil board.

The SEC has weak, non-granular rules requiring that environmental risks be disclosed, and, as noted below, the commission is considering more sharply focused requirements. Criminal enforcements are possible. Litigation risks are evident.

The challenge for the board is not just to say there is risk. The board must identify the risk as specific to the company, assign persons responsible for mitigation, and establish a clear plan to effect that mitigation by giving power to delegates. That plan should address how this progress is going to be paid for and the impact on profit. Consideration should be given to utilizing “green bonds” and government policies as part of the solution.

Much of the discussion revolves around achieving net zero carbon emissions by 2050, with 45 percent reduction in nine years, driven by U.S. federal policy and the Paris Accords. Carbon is difficult because “net” must take into account emissions by suppliers and then by customers.

In late June, SEC Commissioner Allison Herren Lee emphasized the growing commission focus on ESG in general and “E” in particular. Her analysis started with a policy justification: Corporations now run all aspects of our social and economic lives. A 2018 study cited by her claimed that of the 100 largest revenue generators in the entire world, 71 were corporations and only 29 were governments.

Notwithstanding that a review of 100 proxy statements revealed that 78 percent of the companies had a committee charged with environmental matters, Lee decried lack of clear executable corporate plans. Noting that shareholder interest was high, she cited several recent annual meetings, including: 98 percent of GE stockholders voted to ask the company how it planned to reach net zero, 68 percent voted for ConocoPhillips to follow a measure requesting emissions reductions, and 65 percent of United Airlines shareholders voted to receive information concerning the relationship between the Paris Accords and company lobbying practices.

Lee affirmed that the SEC was considering rulemaking to improve climate and other ESG disclosure. In addition to the current generalized disclosure requirement for material risks and omissions, there are in place only some audit requirements, a general risk oversight requirement (Rule 407[h] of Regulation S-K), and a reference to climate in a 2010 guidance for preparing the Management Discussion and Analysis (MD&A) disclosure section.

She also noted the fiduciary duty of boards to, at a minimum, investigate red flags under Delaware law, and ISS and Glass Lewis voting policies punishing ESG failures.

Two closing thoughts from Commissioner Lee were particularly telling. First, she suggested that directors incentive climate risk management by keying executive bonuses to environmental success (claiming that an analogous effort at regulation through executive compensation did increase on-time flight arrivals).

Second, she warned against “woke washing,” the practice of adopting strong corporate policies but failing to adopt consistent actionable plans in implementation.

Finally, you know it’s a new SEC ballgame when the commission quotes Yogi Berra in a speech: “If you don’t know where you are going, you might wind up someplace else.”


Stephen M. Honig practices at Duane Morris in Boston.