When the U.S Supreme Court returns tomorrow from its midwinter break, one of the things corporate lawyers hope the justices will be bringing with them is the decision in Virginia Bankshares v. Sandberg.
The case was argued in October. Its outcome will tell disgruntled stockholders whether they can take their quarrels with the actions -- or inaction -- of a company's board to federal court, where the directors will be without the protections they have developed under state laws.
Regardless of the outcome of the Virginia Bankshares case, directors are a lot more vulnerable to damage suits than they used to be. "Corporate officers and directors have become increasingly concerned about their liability exposure given the volume and nature of the litigation which has been filed against them," said Michael E. Neben, counsel of AON Corp., a Chicago-based insurance holding company.
The most conservative estimate pegs the annual increase in suits filed against corporate officials at 5 percent. The number of suits may be growing three times that fast. A survey by Wyatt Co. shows that the most likely targets are directors of money-losing companies involved in an active merger or divestiture program. Companies with more than 500 stockholders are twice as likely to be sued as those with fewer shareholders. Especially hard hit are firms in the oil, utilities or financial services business.
The Wyatt study said that about one in twenty cases results in the claimants winning over $10 million -- a statistic which pulls the average payment up to $2.2 million. Legal bills run up defending the suit add another 50 percent to the average cost of a claim.
Essentially, judges are knocking holes in what is called the "business judgment rule" -- the old proposition that a court will not substitute its own views on what would have been the right course for the company but will presume that directors acted in good faith that what they were doing would turn out for the best. Of course, it is only the situations that end badly that end up in court.
The rule still stands, but increasingly courts are demanding that, when challenged, the directors prove that they were diligent. Too little time spent debating a major corporate development, possible personal conflicts of interest, or too much reliance on the say-so of corporate officers without independent investigation can all be taken as indications that the directors were lax.
In the Virginia Bankshares case, lower court rulings said the directors could be held personally liable in approving a merger because they didn't hire their own independent expert to evaluate the deal and were at least partially motivated by a desire to continue as directors of the merged entity.
Little wonder, then, that corporate lawyers are telling their chief executives to change the way they make up their boards in the first place and use them in the second.
Neben just provided his colleagues in the American Corporate Counsel Association an outline of reforms that starts with how director candidates are screened and ends with how well minutes of board meetings are archived.
The basic lesson is that top managers have to look to boards to give real advice, not merely to rubber stamp decisions already made by the corporate officers. That means getting persons who will take the job seriously, rather than merely as a prestige feather in their cap.
The company should ask candidates, Neben said, "whether they will have sufficient time not only to attend board meetings but, equally and perhaps more importantly, adequately to prepare in advance for each meeting.
And the company should be ready to pay director fees high enough so the job seems worth doing well.
Meetings should be scheduled when they are convenient for directors -- and changed if a phone poll shows that a number of the outside directors are going to miss a particular date. The outside directors are key to defending against suits, because they are considered the more objective board members.
If an action is challenged in court, it is a lot easier to defend if the company can show that a majority of the outsiders voted for the motion.
The use of outside experts is tricky, Neben cautions.
Seeking an independent view is evidence that directors were carefully weighing their options, not simply going along with everything the management suggested. But it also gives those suing for liability another line of attack: board members have to be careful that the experts they listen to are truly qualified, learned all they should have about the corporation, and in giving advice did not wander beyond their areas of expertise.
The goal is to let the managers manage the company, but to have the directors keep careful supervision over how those managers are doing.
Daniel B. Moskowitz is a Washington editor with Business Week newsletters.