INTRODUCTION I. AN EMPIRICAL INVESTIGATION OF OUTSIDE DIRECTOR LIABILITY A. Trials: Frequency and Outcomes B. Out-of-Pocket Payments by Outside Directors in Settlements C. The Bottom Line II. WHY IS OUT-OF-POCKET LIABILITY SO RARE? A LEGAL ANALYSIS OF SECURITIES AND CORPORATE SUITS A. The Scope of Out-of-Pocket Liability Risk if a Case Is Pursued to Judgment 1. Securities lawsuits 2. Corporate lawsuits--breach of fiduciary duty 3. The resulting windows of out-of-pocket liability exposure B. The Effect of Settlement Incentives in Shareholder Suits 1. Securities lawsuits 2. Fiduciary duty suits C. Lead Plaintiff Motivated To "Send a Message". 1. Solvent company 2. Insolvent company D. The WorldCom and Enron Settlements: What Factors Allowed the Lead Plaintiffs To Extract Personal Payments? 1. The WorldCom settlement 2. The Enron settlement III. OTHER POTENTIAL SOURCES OF OUTSIDE DIRECTOR LIABILITY A. SEC Enforcement Actions B. ERISA CONCLUSION APPENDIX A. SURVEY DESIGN APPENDIX B. DETAILS OF SECURITIES AND CORPORATE LAW TRIALS A. Securities Law Trials B. Corporate Law Trials INTRODUCTION
This Article analyzes outside director liability risk empirically, legally, and conceptually. Concern over liability for outside directors has arisen periodically since the 1970s, typically in response to specific events that appear to expose outside directors to heightened risk. (1) Outside director liability is again causing much concern, with the current trigger being the 2005 securities class action settlements involving WorldCom and Enron. In these settlements, outside directors agreed to make substantial payments out of their own pockets to settle securities class action lawsuits even though there was no evidence in either case that the outside directors knowingly participated in fraudulent activity.
The WorldCom securities class action arose out of the largest bankruptcy in U.S. history. (2) The company's twelve outside directors personally paid $24.75 million as part of a settlement with a plaintiff class led by the New York State Common Retirement Fund (NYSCRF). The Enron securities class action arose out of the second-largest bankruptcy in U.S. history; in this case, ten outside directors paid $13 million out of their own pockets to settle claims against them. In addition, the Enron outside directors paid $1.5 million to settle a suit by the U.S. Department of Labor (DoL) under the Employment Retirement Income Security Act (ERISA). In both settlements, the lead plaintiff insisted on personal payments by the outside directors. In announcing the WorldCom settlement, Alan Hevesi, the Comptroller of the State of New York and Trustee of the NYSCRF, stated that the payments were intended to send "a strong message to the directors of every publicly traded company that they must be vigilant guardians for the shareholders they represent.... We will hold them personally liable if they allow management of the companies on whose boards they sit to commit fraud." (3)
Press reports of the WorldCom and Enron settlements emphasized that they represented disturbing precedents for outside directors. For example, Richard Breeden, former chairman of the Securities and Exchange Commission (SEC), opined that the WorldCom deal "will send a shudder through boardrooms across America and has the potential to change the rules of the game." (4) Law firm client memos supported this view. (5) Many believe that lead plaintiffs in securities suits will follow the WorldCom and Enron script by seeking personal payments from outside directors as a condition of settlement and will succeed in extracting such payments.
Outside directors' anxiety about legal liability was high prior to the WorldCom and Enron settlements. The conventional wisdom was that being an outside director of a public company was risky. Fear of liability has for some time been a leading reason why potential candidates turn down board positions. (6) The WorldCom and Enron settlements have heightened these fears. (7) Outside directors are not worded about liability for self-dealing, insider trading, or other dishonest behavior. These actions indeed entail significant liability risk, but a director can avoid that risk by refraining from engaging in suspect actions. Outside directors are concerned instead that, as in WorldCom and Enron, they will be sued for oversight failures when, unbeknownst to them, management has behaved badly; that neither indemnification by the company nor D&O liability insurance will fully protect them; and that they will therefore bear "out-of-pocket" liability. (8)
We address in a separate article the normative question of the degree to which outside directors should bear out-of-pocket liability risk for oversight failures. (9) Regardless of one's position on the issue, however, all would agree that, beyond some level of liability risk, qualified people may decide not to serve as directors and that those who do serve may become excessively cautious. Too much fear of liability, therefore, may reduce rather than enhance the quality of board decisions. But before one can assess the proper scope of outside directors' out-of-pocket liability risk or the need for reform, one needs to understand the actual extent of that risk under the current legal regime.
This Article addresses the following questions: How often have outside directors paid damages, or even legal expenses, out of their own pockets--either pursuant to a judgment or a settlement? Under what circumstances are outside directors likely to face out-of-pocket liability when a lawsuit launched by shareholders or creditors under corporate or securities law goes to trial? What conditions need to be in place for an outside director to make an out-of-pocket payment when a shareholder suit settles? How often will lead plaintiffs such as NYSCRF try to extract out-of-pocket payments from outside directors? If they try, how likely are they to succeed? Do the WorldCom and Enron settlements reflect a major change in the underlying dynamics of shareholder suits that increase the risk of out-of-pocket payments by outside directors in cases involving oversight failures? Do other sources of risk, such as enforcement by the SEC or suits brought under ERISA, alter matters by creating substantial out-of-pocket liability risk?
We begin with the results of an extensive empirical investigation of outside director liability. We find that out-of-pocket payments by outside directors are rare. Companies and their directors are frequently sued under the securities laws and state corporate law, and settlements are common. But the actual payments are nearly always made by the companies involved--either directly or pursuant to directors' rights to indemnification (10)--or by a D&O insurer, a major shareholder, or another third party. Since 1980, outside directors have only once made personal payments after a trial. That was in the famous Van Gorkom case in 1985. (11) We found an additional twelve cases in which outside directors made out-of-pocket settlement payments or payments for their own legal expenses. Ten of those cases involved claims of oversight failure; two involved duty of loyalty claims; and one involved an allegedly ultra vires transaction involving the directors' compensation. (We count two payments by the Enron outside directors, in a securities case and an ERISA case, as one instance.) Most of the oversight cases involved fact patterns that should not recur today for a company with a state-of-the-art (12) D&O insurance policy.
We then explain the rarity of out-of-pocket payments in shareholder suits by analyzing the complex interaction of multiple factors: (1) substantive liability rules; (2) procedural hurdles that plaintiffs must overcome to win a damage judgment against outside directors; (3) indemnification and D&O insurance, which prevent "nominal liability" (13) for settlement payments, damage awards, or legal expenses from turning into out-of-pocket liability; and (4) settlement incentives. Our analysis reveals a narrow set of circumstances in which outside directors face a risk of a judgment against them that could result in out-of-pocket liability. Setting aside self-dealing and other dishonest behavior, the window of exposure was narrow prior to WorldCom and Enron, and it remains narrow today. (14)
We next analyze settlement incentives that arise in the shadow of the outside directors' exposure to an actual finding of liability following a trial. Settlement incentives sharply narrow the already limited level of out-of-pocket liability risk. Once settlement incentives are considered, outside directors face significant risk primarily in two situations. One situation, which we call a "perfect storm," requires the confluence of the following elements: (1) the company is insolvent and the expected damage award exceeds the amount the company can pay plus the limit on the company's insurance policy; (2) the case includes either a large claim under section 11 of the Securities Act of 1933 (Securities Act) or a large and unusually strong claim against the outside directors under section 10(b) of the Securities Exchange Act of 1934 (Exchange Act); and (3) there is an alignment between individual culpability and personal wealth among the officers, directors, or both. Even if these conditions are met, however, an outside director may still be protected from out-of-pocket liability if his company provides its directors with supplemental insurance coverage that is separate from that covering the company and the inside managers. Perfect storms have happened and they can happen again, but they are rare.
The second out-of-pocket liability scenario, which we call "can't afford to win," occurs when the company is insolvent, and, due to a lack of D&O insurance or insufficient coverage, an outside director must pay his own litigation expenses to defend a suit. Under these conditions, even a director facing a...