Over the last year and more, the financial press has been giving great attention to the corporate reforms imposed on public companies under the federal Sarbanes-Oxley Act (S-OX) of 2002. Many of these changes are intended to shift power within the board room from executive management back to the corporation's directors, especially its outside, independent directors. The new listing requirements for publicly—traded companies on the NASDAQ and New York stock exchanges are much in the same vein.
Less publicized is the powerful ripple effect these federal laws are having on the corporate governance of privately-held companies, charitable foundations and not-for-profit organizations.
To avoid being marginalized by the federal corporate law of S-OX, the chancery court of Delaware, the pre-eminent arbiter of business law most often followed by the other state courts, is now clearly committed to raising the legal standards of acceptable director and officer diligence and conduct. For example, in a momentous departure from prior rulings, the Delaware court has refused to defer to the business judgment of Disney's board of directors, but instead allowed a shareholder derivative action to proceed against the board for allegedly over-compensating its former president, Michael Ovitz. In another recent case, the Delaware court decided that two Stanford academics, serving as directors on the Oracle board, could not be deemed "independent" of management because of major charitable donations to Stanford by the company and its top executives — again a significant change of legal standards from what had existed in Delaware prior to S-OX. Removing any doubt as to Delaware's new-found policy of raising the bar to require more diligent board oversight over management, the chief justice of its supreme court recently spoke plainly to a gathering of institutional shareholders: "The courts should examine (board) processes and examine them carefully. Directors should not just go along, as maybe they did years ago."
Other courts are likewise paying attention to more demanding corporate governance standards under both S-OX and Delaware business law. The prestigious federal court of the southern district of New York, in a crushing 242-page decision, imposed legal liability on the directors and officers of a private company for their lack of diligence in preventing tens of millions of dollars from being wrongfully tapped by its CEO, a former owner of the ‘21' Club. But that was only a civil case. As of this writing, a much publicized criminal trial is taking place in Germany, where an outside director of Mannesmann, who also heads that country's largest bank, Deutsche Bank, is criminally charged for permitting a gross over-compensation of Mannesmann executives. As in the New York and Delaware cases, the German directors were not accused of personally benefiting from their actions. Rather, it is their inaction, lack of independence, and undue deference to management that landed them in court.
Outside the corporate world, private charitable foundations have come under fire in recent months by press exposes spotlighting abusive levels of compensation paid to trustees — at times far in excess of annual grants made by the charity. Stung by the public embarrassment of these media scandals, governmental regulators, federal and state, have promised to take action. Enforcement officials in Massachusetts and New York are starting to crack-down on inattentive boards and over-paid trustees. The Internal Revenue Service has also announced its intent to require tax-exempt organizations to comply with governance standards and practices akin to those called for under S-OX and Delaware business law.
The notoriety of scandal and abuse perpetuated by greedy executives of a few public companies, unsupervised by the directors of complacent if not complicit boards, has unleashed a wave of more rigorous legal standards of director diligence, conduct and liability for the boards of private businesses, charitable foundations, and not-for-profits. Going forward, public and private board members will be obliged to work harder, ask more questions, and defer less to management in discharging their oversight responsibilities. The sea-change of S-OX is not just about public companies any more.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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