Reprint: Preliminary Report of the American Bar Association Task Force on Corporate Responsibility

• Jurisdiction: United States,Federal
• Publication year: 2003
• Citation: Vol. 54 No. 2

PRELIMINARY REPORT OF THE

AMERICAN BAR ASSOCIATION

TASK FORCE ON CORPORATE

RESPONSIBILITY^*

July 16, 2002

TASK FORCE

James H. Cheek, III, Chair

Thomas A. Gottschalk

Nell Hennessy

R. William Ide III Charles E. McCallum

Robert H. Mundheim John F. Olson

Aulana L. Peters

Dean Joel Seligman

Hon. Ben F. Tennille

Solomon B. Watson, IV

Prof. Lawrence A. Hamermesh,

Reporter

Liaisons:

ABA Board of Governors: Leslie W. Jacobs

Section of International Law: John A. Kelley

Section of Litigation: Brad D. Brian

Section of Taxation: Stuart J. Offer

PRELIMINARY REPORT OF

THE ABA TASK FORCE ON

CORPORATE RESPONSIBILITY

July 16, 2002

On March 28, 2002, Robert Hirshon, President of the American Bar Association, appointed a task force with the following charge:

The Task Force on Corporate Responsibility shall examine systemic issues relating to corporate responsibility arising out of the unexpected and traumatic bankruptcy of Enron and other Enronlike situations which have shaken confidence in the effectiveness of the governance and disclosure systems applicable to public companies in the United States. The Task Force will examine the framework oflaws and regulations and ethical principles governing the roles of lawyers, executive officers, directors, and other key participants. The issues will be studied in the context of the system of checks and balances designed to enhance the public trust in corporate integrity and responsibility. The Task Force will allow the ABA to contribute its perspectives to the dialogue now occurring among regulators, legislators, major financial markets and other organizations focusing on legislative and regulatory reform to improve corporate responsibility.

The Task Force respectfully submits this preliminary report in response to that charge. The report is the product of extended meetings of the full Task Force, numerous formal and informal meetings of various subgroups ofthe Task Force, and the fund ofprofessional experience and judgment that the members of the Task Force bring to bear.¹

This preliminary report is intended to serve as a vehicle to elicit comments from interested observers, within the ABA and elsewhere, through a written comment process and one or more public hearings to be scheduled this fall. With such input, the Task Force intends to generate a final report before the end of 2002.

The Task Force's recommendations are set out and explained below. They are recited in summary outline form in Exhibit A to this report. Not all members of the Task Force endorse each recommendation and view expressed in this report, but the report taken as a whole reflects a consensus of the members of the Task Force.

The views expressed herein have not been approved by the House of Delegates or the Board of Governors of the American Bar Association and, accordingly, should not be considered as representing the policy of the American Bar Association.

I. INTRODUCTION AND OVERVIEW

A. Background of Recent Failures of Corporate Responsibility

Few events in business history since the Great Depression have had the public impact of the stunning collapse of Enron Corp. and other major companies in the past year. Although President Hirshon's charge to the Task Force specifically refers to Enron, that company is merely one of the most notorious in a disturbing series of recent lapses at large corporations involving false or misleading financial statements and alleged misconduct by executive officers.² Investor confidence in the quality and integrity of public company corporate governance is compromised, and the pace of calls by the President, Congress, the SEC, stock markets and other interested groups for regulatory reform has quickened dramatically.³

Given the charge to the Task Force to examine "systemic issues relating to corporate responsibility," the threshold consideration in evaluating recent failures in "corporate responsibility" is defining that term. At the very least, "corporate responsibility" should be understood to include behavior by the executive officers and directors of the corporation that conforms to law and results from the proper exercise of the fiduciary duties of care and loyalty to the corporation and its shareholders. In the Task Force's view, moreover, the term "corporate responsibility" also embraces ethical behavior beyond that demanded by minimum legal requirements.⁴ Participants in the corporate governance process require a fresh recognition that executives are employees, and that corporate responsibility can only be achieved when officers and directors both recognize that they are obliged to advance the interests of others. In their roles as corporate fiduciaries, the corporation does not belong to them.

Judged by this concept of corporate responsibility, the system of corporate governance at many public companies has failed dramatically. It is a clear failure of corporate responsibility, for example, if a corporation belatedly and precipitously discloses that the equity on its balance sheet has been overstated by billions of dollars. It is a clear failure of corporate responsibility if employees whose retirement accounts are heavily invested in the corporation's stock are assured by management of the corporation's financial prospects and then discover that the value of that stock has promptly vanished as a result of earnings misstatements and self-dealing by corporate officers. It is a clear failure of corporate responsibility if executive officers aware of potential accounting irregularities sell millions of dollars ofstock to public investors who are unaware ofsuch information. It is a clear failure of corporate responsibility for insiders to borrow enormous amounts from their companies without adequate security beyond inflated stock of the company itself. And it is a clear failure of corporate responsibility when outside directors, auditors and lawyers, who have important roles in our system of independent checks on the corporation's management, fail to avert or even discover - and sometimes actually condone or contribute toward the creation of - the grossest of financial manipulations and fraud.

At least with the benefit of hindsight, the 1990's can be seen to have created a potent recipe for failures of corporate responsibility. Among other things:

X Stock prices grew enormously and almost continuously, leading many investors to expect double digit annual returns on investment as a matter of course.⁵ Executive officers were expected to meet growth expectations of Wall Street analysts that became increasingly unrealistic. The only hope for meeting expectations was a willingness to undertake significant risk or to manipulate data so that they would indicate the desired results.

X Aided by dramatic stock price growth, equity-based executive compensation - particularly in the form of stock options - as a means intended to align the interests ofmanagers and shareholders became increasingly prevalent and lucrative. There were unanticipated consequences. Executive officers were endowed with powerful personal incentives to meet near term Wall Street earnings expectations and to avoid any negative impact upon current stockmarket prices.⁶ Directors faced significant pressures to produce executive compensation and benefit packages that were attractive in an ever-escalating executive compensation marketplace. The reasonableness of compensation and its structure, as well as the motivations being created, may not have received sufficient independent consideration.

X Outside professionals hired by the corporation - particularly its accountants and lawyers - faced increasing pressures of consolidation and global competition, and they found it necessary to compete more keenly to identify ways to enhance their relationships with their corporate clients. As accounting and law firms grew larger, the need increased to put in place internal controls that would allow those firms to assure the necessary quality controls and independent judgment. Corporate executives' self-interest in assuring a rising corporate stock price, and the frequent need to be aggressive in accounting matters and in assuming business risks were not tempered by the checks and balances which the general corporate governance scheme expected from outside directors and professional firms engaged by the corporation to provide independent review and advice. Questionable treatment of financial information evaded audit screens, and important disclosures were not made. Unfortunately, judgments at all levels of the governance system were compromised and, in too many instances, seriously flawed.

B. Identifying Critical Causes of Failures of Corporate Responsibility

The Task Force believes that most executive officers, directors and professional advisers act honestly and in good faith. Direct operational control of American public companies is and must remain primarily in the hands of their executive officers. It has always been recognized, however, that executive officers and other employees ofpublic companies may succumb to the temptation to serve personal interests in maximizing their own wealth or control at the expense of long-term corporate well-being. To check such temptation, and to focus the corporation on the interests ofthe shareholders, our system ofcorporate governance has long relied upon the active oversight and advice of independent participants in the corporate governance process, such as the outside directors, outside auditors and outside counsel. Corporate responsibility and sound corporate governance thus depend upon the active and informed participation of independent directors and advisers who act vigorously in the best interests of the corporation and are empowered effectively to exercise their responsibilities.

The core conclusion of the Task Force, however, is that, as evidenced by recent failures of corporate responsibility, the exercise by such independent participants of active and informed stewardship of...