A shock to the system

In January 2005, Corporate America took notice when the outside directors of the two companies most closely associated with corporate scandal - Enron and WorldCom - agreed to settle the securities class action cases involving those companies. The startling aspect of the settlements was that many of the directors agreed to contribute their personal funds, in excess of the contributions from their respective directors and officers insurance policies. In Enron, ten of the eighteen settling directors agreed to contribute $13 million to a total settlement of $168 million, with the remaining $155 million to be paid by insurers. The lead plaintiff in the case reported that the directors' contribution reflected a portion of their profits from selling Enron stock. In WorldCom, ten settling directors agreed to contribute $18 million to a total settlement of $54 million, with the remaining $36 million to be paid by insurers. The lead plaintiff in the case reported that the $18 million represented approximately 20% of the directors' aggregate wealth, not counting primary residences and retirement accounts.

As in all cases, these settlements do not constitute admissions of liability or wrongdoing by any of the settling directors. Moreover, as both cases are federal court class actions, the settlements are subject to court approval under Federal Rule of Civil Procedure 23(e). This requirement already has proven significant: Judge Denise Cote promptly rejected an element of the proposed WorldCom settlement, leading to the settlement's termination by the lead plaintiff.

Despite that reversal, the two settlements warrant the attention that they have received. In the past, it has been rare for individual defendants to contribute personal funds to securities settlements. A Stanford University professor and his students found only four such instances through 2003. In 2004, however, the former chairman of Global Crossing contributed $30 million to a securities \ ERISA class action settlement, and a Delaware court held an outside director liable for approving an unfair price in a going private transaction in breach of his duties of loyalty or care to the shareholders. The WorldCom and Enron settlements only increase the debate and speculation of whether directors will face a substantially heightened risk of personal liability from their service as directors.

There are several reasons why directors should not automatically dismiss the WorldCom and Enron settlements as completely aberrational products of notorious cases. First, they may create expectations about the contours of future settlements. Plaintiffs' firms are more competitive than ever in the quest to represent institutional investors and secure lucrative leadership positions in securities class action litigation. Both these firms and their institutional clients will look to the WorldCom and Enron settlements as benchmarks, and may increase the pressure for individuals to contribute personal funds to settlements. Second, the heightened scrutiny of corporate governance practices produced by the cases has not abated. Instead, the scrutiny has been written into law by the Sarbanes-Oxley Act, and magnified by subsequent investigations into other purported scandals (such as those involving mutual funds and insurance brokers). With tougher standards come more potential for error and less tolerance for perceived malfeasance. Third, while the WorldCom and Enron facts were extreme (as discussed below), by and large the legal theories used to sue the directors in these cases were not. Directors always have had duties under the Securities Act to see that their corporations issue truthful registration statements when conducting public offerings, duties under the Exchange Act to not issue false or misleading statements to investors, and duties of due care and loyalty to the shareholders under corporation law.

Rather than disregard the prospect that Enron and WorldCom portend the future, the wiser course for directors (and prospective directors) is to ask what the cases teach about the risks of serving on a company's Board of Directors. Fortunately, there is considerable information in the public record about the two cases, beyond the allegations of the complaints. For WorldCom, this can be found in the summary judgment rulings, which report facts gleaned from discovery (which has been completed). For Enron, depositions have just started in anticipation of an October 2006 trial, and summary judgment motions have not yet been decided. However, a Senate subcommittee issued a detailed report on Enron's outside directors, which refers to an earlier report commissioned by a Special Committee of the company. Many of the factual representations in these public sources have not been tested in the adversary process; that is one reason why both cases are proceeding to trial against the non-settling defendants. However, there is enough public information to identify factors from the cases that increase the risks presented to the directors of a public companies.

The company's presence in the securities markets

One common factor to the Enron and WorldCom settlements is that the theoretical damages in both cases were substantial, due to the companies' previously robust presence in the securities markets. It makes sense to conclude that the damages would be substantial. Both Enron and WorldCom were actively traded stocks with huge market capitalization. Hence, the theoretical value of the claims of investors who lost practically everything when the companies entered bankruptcy was substantial. The potential for large damages undoubtedly motivated a major player in WorldCom, Citigroup, to pay $2.65 billion to settle the case; and led to settlements with just three of the many institutional defendants in Enron of $333 million.

Enron's and WorldCom's presence in the securities markets was more than a matter of large market capitalization and trading volume: the issuers themselves were active in the markets. Both WorldCom and Enron conducted public offerings during the periods in which their financial statements were fraudulent. As a result, their directors faced claims under Section 11 of the Securities Act, which allows liability without an intent to defraud. This probably factored heavily into the directors' agreement to contribute to settlements, even though the courts had dismissed the most serious claims (for securities fraud) against many of the directors. On a similar note, the Enron directors also faced control person liability claims under Section 20(a) of the Exchange Act, which the Court held did not require allegations of an intent to defraud.

In assessing their liability profile, a director can consider where his or her company stands on this market presence risk factor. Many directors will find themselves subject to a high risk: large theoretical damages always are present when an issuer's stock prices is volatile, and/or when it enjoys large market capitalization; and many companies conduct public offerings, and hence subject their directors to Section 11 liability. A good first response is to adjust the amount of directors and officers insurance to match the market presence risk. Directors also can take some comfort in the fact that size alone cannot account for the Enron and WorldCom settlements. Other securities class action cases have experienced large theoretical damages, and large settlements, without contribution from individual directors. Hence, other factors must have been at work in accounting for Enron and WorldCom.

Too good to be true

In some respects, the Enron and WorldCom frauds were very different. At Enron, according to the Senate Report and the class action allegations, the company engaged in a flurry of highly complex transactions (involving such features as special purpose entities, off balance sheet expenses, and sales without economic substance) whose basic contours were well known within the company, its auditors, and its Board of Directors; but whose cumulative implications for Enron's financial statements and prospects were (at a minimum) not fully appreciated by the directors and not adequately disclosed to investors. In other words, it was a complex fraud that hid largely in plain sight. At WorldCom, the bulk of the fraud was accomplished by a single accounting error - capitalizing rather than expensing the costs of building transmission lines - implemented and concealed by surreptitious journal entries and double sets of books. For example, after a monthly report that documented the discrepancy between actual and reported line expenditures was distributed, one WorldCom co-conspirator e-mailed a colleague, "Where do I sign my confession?," and another asked why the report had been circulated at all. This was a simpler fraud that was largely hidden.

Despite the different nature of the accounting malfeasance involved in the two cases, a common thread and risk factor can be found in the reported effects of that malfeasance: both companies engaged in transactions, or reported numbers, that were seen in hindsight as just too good to be true. The Senate Report points to two key examples of this at Enron. The Report chastised the directors for not making inquiries when told that the LJM limited partnerships created by Enron to engage in transactions with the company had produced fantastic benefits for Enron in a very short period of time. It also criticized the directors for approving "hedging" transactions with other off-balance sheet entities (the so-called Raptors) that were collateralized by Enron stock, and hence did not actually hedge risk. The directors allegedly should have recognized that the transactions were illegitimate accounting shenanigans, because their very structure showed that their sole purpose was to improve the appearance of Enron's financial statements. In both instances, the tenor of the Report is that the directors should have been suspicious and demanding of further inquiry and disclosure when they observed transactions and results that were just too good to be true.

For WorldCom, one reason why the underwriters did not win summary judgment was that they did not show that they had investigated further upon learning from publicly reported financials that WorldCom's reported ratio of its line cost expenses to revenues - the key metric assessed by securities analysts - "was significantly lower than that of the equivalent numbers of its two closest competitors, Sprint and AT & T." In other words, here, too, the company reported numbers that (from the hindsight of subsequent discoveries) were too good to be true. This calls to mind another recent accounting scandal involving numbers that proved too good to be true: speech recognition software company Lernout & Hauspie, which (according to a reviewing court) suddenly reported "jaw dropping" levels of sales from its Korea subsidiary that soon proved to be the result of fraudulent transactions. The WorldCom opinions do not explicitly state that the significantly lower line cost expenses were known to the directors, but as the information was public, and as the metric was so significant to Wall Street's perception of the company, the plaintiffs could have been expected to raise the point against those directors who did not settle.

This risk factor presents a quandary. Most companies (and their shareholders) hope and expect that they will succeed and grow. In high technology industries, explosive growth is quite natural and legitimate. Success should not signal a red flag per se, either to directors or to courts. At the same time, however, a lesson of Enron and WorldCom is that directors should monitor the key metrics of the company's business, divisions and segments, and assure themselves that any tremendous increases in success are the result of understandable accounting and business judgments that can be defended in the light of full disclosure. The failure to respond to this risk can mean that the directors will be faulted if the numbers or types of transactions that look too good to be true are too good to be true, regardless of whether the result is the product of a simple error (WorldCom) or complex transactions (Enron). This is not to say that complexity cannot be an independent factor. As a matter of law, it should be the case that the more complex an accounting principles applicable to a transaction, the more difficult it is to plead and prove that a defendant knowingly broke the rules in accounting for the transaction. As a matter of practice, however, we will see below that the complexity of a company's transactions creates additional risks for directors.

Executive risk

A third type of risk factor from Enron and WorldCom is the presence of issues regarding executive compensation and finances. Here, however, it is the difference rather than the similarity between the cases that signals the risk of which directors should be wary.

An example of the executive finance factor that is common to the cases is that at both companies, the CEO's personal finances were heavily dependent on the price of the company stock. To date, however, this point has not proven significant. In WorldCom, the investment banks prevailed at summary judgment on the issue of whether their knowledge of the CEO's precarious personal finances imposed additional duties to inquire whether he was causing the company to engage in fraud, as "plaintiffs had not shown the banks had any reason to believe that [the CEO] would use his access and power to commit fraud." In Enron, the plaintiffs did not need this type of allegation to state a securities fraud claim against the CEO, and did not state a claim against the outside directors despite the availability of this type of allegation.

Instead, the risk factor regarding executives that emerges from the two cases comes from Enron alone: excess compensation. The Senate Report faulted the directors for allowing certain officers to make substantial trading profits from the exercise of stock options as part of a "culture driven by compensation." In addition, substantial cash bonuses ($750 million in one year alone) were awarded by the company, apparently without notice or comment by the directors. The Compensation Committee also did not monitor a revolving credit line provided to the CEO. Worst of all (from the Senate Report's point of view), the Board of Directors allowed the company's CFO and his undisclosed investment partners to form the LJM limited partnerships, which engaged in purportedly arms-length transactions with the company. If the directors' approval of this apparent conflict of interest was not bad enough in itself, the CFO and his colleagues made large cash profits from the transactions in which they engaged. The Chair of that Compensation Committee did not inquire into these profits until alerted to the issue by an article in the press, and never received the compensation information about the company's Section 16 officers he requested from an Enron employee.

The impact of the excess executive compensation risk factor is indirect. It is not clear that Enron's ultimate failure was caused by excess executive compensation alone. Moreover, even after Enron, many companies - public or private, large or small - have compensation-driven cultures. Furthermore, many public companies use stock options, and that fact too should not raise concern. The ultimate lesson from Enron is that the failure to prevent excess executive compensation and disclose it when it is evident will subject directors to criticism - as occurred in the Senate Report - regarding what other problems they would have discovered had they inquired more about why the executives were earning so much compensation. Indeed, in the securities class action case. the Court found that the directors' waiver of the CFO's conflict in two of the limited partnerships was "the closest that Lead Plaintiff comes to pleading scienter," as the "waiver was contrary to established Enron policy and created a possibility for fraud...." The allegation was insufficient only because the waiver was within the board's power and "the attendees were reassured that there would be identified checks on [the CFO's] power." The failure of these "identified checks" is a subject of the final risk factor, as discussed below

Structural barriers to effective Board oversight

A final set of risk factors that may be drawn from the circumstances of Enron and WorldCom is that there may be structural barriers to the directors' effective oversight of a company's critical accounting and disclosure decisions. At the outset, we observe that the companies' boards of directors were quite large. The Senate Report notes that in the final full year of Enron's existence (2001), its board consisted of fifteen directors, of which only two were company officers. There are twelve outside director defendants in the WorldCom case, and in the moments before the company's downfall, it was in the process of asking shareholders to elect a board of eleven persons. In the abstract, a larger board with more directors possesses more knowledge and resources ready to devote to the totality of the board's functions. In practice, the large boards at Enron and WorldCom did not allow the directors as a body to prevent, detect or correct the respective frauds.

For Enron, in particular, the size and structure of the Board may have hindered the effective oversight of the company's complex transactions. A subtle but striking element of the Senate Report is that it discloses that while Enron collapsed as a result of an accounting and disclosure fraud, it was not the Audit Committee of the board that reviewed the transactions that caused the collapse. Instead, the limited partnership, off balance sheet, and other complex transactions and offerings were vetted by a separate Finance Committee, which did not meet separately with the company's outside auditors and which shared only one member with the Audit Committee. The Audit Committee, for its part, did not generally hear presentations from the senior executives of the company (although they attended meetings). Thus, there was a disconnect between the names of the Committees as they existed on paper, and the responsibilities of the Committees to review the decisions that had such a crucial impact on the company's accounting for its financial statements.

The Enron board structure also was suboptimal when it came to responsibilities that crossed Committee lines. As to one set of the most critical (and criticized) decision made by the board, as noted above, the Court noted that the directors relied on assurances that the CFO's authority would be checked in deciding to approve the limited partnerships. The Finance Committee, however, did not follow through on the controls it formulated to provide this check, and the Compensation Committee did not do its part by collecting compensation information. As to the other set of critical and criticized decisions of the board, a director defended the Raptor and limited partnership off balance sheet transactions on the basis that they were proper so long as they were disclosed. The Senate Report, albeit in hindsight, found the disclosures inadequate, especially when compared to the disclosure provided after the situation had become public knowledge. There is no indication in the Report of the structural mechanism in place to ensure the accuracy and (in this case) completeness of Enron's public disclosures, despite the fact that disclosure was required to justify the off balance sheet transactions.

To be certain, the Enron-related risks of a suboptimal board structure have been addressed by Sarbanes-Oxley, which now requires review and attestation of disclosure controls and prescribes the duties of Audit Committees; and by the required disclosure of critical accounting estimates. Still, it is impossible to foresee every means by which a board structure may fail, and it is here where the complexity of a company's transactions and business model create greater risk in practice. As in Enron, the more complex a transaction, the more implications it will have on other elements of the company, including disclosure. Directors must recognize this as an inherent risk of complexity, and should increase their own efforts accordingly with the assistance of retained experts and legal counsel. This calls to mind the recent observation in WorldCom that while underwriters need not hire auditors to rehash the work of the issuer's auditors in preparing registration statements, a prudent underwriter may choose to consult their own experts if they encounter "aggressive or unusual accounting strategies" by the issuer.

Conclusion

The Enron and WorldCom settlements do not mean that corporate directors should abandon their positions or squirrel their assets in judgment-proof jurisdictions. Instead, judging from the alleged evidence in the public record, the cases provide two examples of how directors can recognize and reduce their risks of liability.

Footnotes

[1] See press release, UC reaches $168-million settlement with Enron directors in securities fraud case (Jan. 7, 2005) (www.universityofcalifornia.edu/news/2005/jan07.html). Eight other directors also participated in the settlement, without contributing personal funds. Id.

[2] See press release, Hevesi Announces Historic Settlement, Former WorldCom Directors to Pay From Own Pockets (Jan. 7, 2005) (www.osc.state.ny.us/press/releases/jan05/010705.htm).

[3] See In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), slip op. (S.D.N.Y. Feb. 2, 2005). Judge Cote stated that an opinion setting forth her reasons for the rejection of the settlement will follow, and hence we will obtain a complete understanding of the matter at a later time. Id. In her initial order, Judge Cote found that a provision of the settlement that would have adjusted the judgment reduction credit to the non-settling defendants to reflect limitations on the financial capabilities of the settling directors violated the judgment reduction statute applicable to federal securities cases, 15 U.S.C. § 78u-4(f)(7)(B)(i). That statute entitles non-settling defendants to a credit equal to the greater of the settling parties' responsibility for damages and the amount paid in the settlement. According to press accounts, the proposed settlement would have limited the judgment reduction credit to $90 million.

[4] See Jonathan D. Glater, A Big New Worry For Corporate Directors, New York Times (Jan. 6, 2005) (published on NewYorkTimes.com) (reporting on research of Professor Michael Klausner).

[5] See In re Global Crossing Sec. & ERISA Litig., No. 02 MD 1472 (GEL), 2004 WL 2724076 (S.D.N.Y. Nov. 24, 2004) (approving settlement); In re Emerging Communications, Inc. Shareholders Litig., No. Civ. A. 16415, 2004 WL 1305745, **39-40 (Del. Ch. June 4, 2004).

[6] See In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), ___ F. Supp. 2d ___, 2005 WL 89395 (S.D.N.Y. Jan. 18, 2005) (denying auditors' motion for summary judgment); In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), ___ F. Supp. 2d ___, 2004 WL 2924601 (S.D.N.Y. Dec. 15, 2004) (granting in part plaintiffs' motion for partial summary judgment, and denying in most respects non-settling underwriters' motion for summary judgment). In addition, new information is being reported on a daily basis as this article goes to press from the testimony in the criminal trial of the company's former CEO. See, e.g., Reuters, WorldCom's Sullivan: Ebbers wanted the numbers "hit" (Feb. 8, 2005) (www.reuters.com/financeNewsArticle etc.).

[7] United States Senate Committee on Governmental Affairs, Permanent Subcommittee on Investigations, The Role of The Board of Directors in Enron's Collapse, Report No. 107-70 (107th Cong., 2d Session) (July 8, 2002) (hereafter "Senate Report").

[8] We are not aware of any published damages assessment in Enron; in the course of reporting on WorldCom, a $13 billion to $20 billion range was projected as plaintiffs' damages claim.

[9] See In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2004 WL 2591402 (S.D.N.Y. Nov, 12, 2004) (granting preliminary approval of partial settlement); UC reaches $168-million settlement with Enron directors in securities fraud case, n.1, supra.

[10] See In re Enron Corp. Securities, Derivative & Erisa Litig., 258 F. Supp. 2d 576 (S.D. Tex. 2003) (dismissing fraud but not control person claims against directors);; In re WorldCom, Inc. Sec. Litig., Nos. 02 Civ. 3288 (DLC) etc., 2003 WL 21219049, *24 (S.D.N.Y. May 19, 2003) (dismissing claims against Audit Committee directors).

[11] In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at **7-8; see also Bloomberg.com, WorldCom Needed Two Sets of Books, E-Mail at Ebbers Trial Says (Feb. 8, 2005) (quote.bloomberg.com/apps/news?pid=10000006&sid=aQerrI.uGFyA&refer=home). Prior to the capitalization error, the company had attempted to deflate reported line costs by improperly depleting reserves and changing the assumptions used to calculate them. In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at *7; see also WorldCom's Sullivan: Ebbers wanted the numbers "hit", n.6, supra (CFO testified that he presented $133 million in unsupported reserve adjustments to CEO, prior to capitalization ruse).

[12] Interestingly, as against the outside auditors, plaintiffs also allege fraud in earlier financial statements for which the auditors have not withdrawn their certification, and that were not affected by the improper line cost capitalization, based on the improper recording of goodwill and improper asset depreciation amortization periods. The court has allowed these claims to proceed, although it did grant judgment for the auditors on a claim that in-process research and development credit was misstated. In re WorldCom, Inc. Sec. Litig., 2005 WL 89395 at n.28.

[13] See Senate Report at 22, 32-33 (questioning why directors had not inquired when told that one partnership, LJM 2, had produced $2 billion in funds flow and over $200 million in earnings in one quarter alone).

[14] See id. at 41-44.

[15] In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at *43 & n.47.

[16] See In re Lernout & Hauspie Sec. Litig, 208 F. Supp. 2d 74 (D. Mass. 2002) (denying officers' motion to dismiss).

[17] See David Priebe and Henry C. Montgomery, Enron Provides Lesson on Audits For Accountants & Public Companies, 17:14 Washington Legal Foundation Legal Backgrounder at 2 (Mar. 8, 2002) ("Assume that others will reach an opposite conclusion on issues that can go either way, and that these dissenting judgments will be disclosed. Would the auditor still be willing to support his judgment?").

[18] See Shirli Fabbri Weiss and David Priebe, Financial Fraud Lawsuits: The Case For Stricter Judicial Scrutiny, 7:5 Andrews Securities Litigation and Regulation Reporter 15, at n.14 (Sept. 26, 2001).

[19] In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at **6-7 (CEO had "pledged essentially all of his WorldCom stock to secure loans that he used to acquire other businesses and to fund their operations," and as stock price declined enteredb into forward sales and experienced margin calls). For Enron, it has been reported that the CEO sold stock as the company's stock price declined in order to meet margin calls.

[20] In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at *45.

[21] See In re Enron Corp. Securities, Derivative & Erisa Litig., Nos. MDL-1446, Civ. A. H-01-3624, 2003 WL 21418157, **15-16 (S.D. Tex. Apr. 24, 2003) ("The complaint sets out numerous, prominent instances where [the CEO] allegedly made untrue or misleading statements of material fact in violation of § 10b, which the Court does not consider it necessary to list.").

[22] See Senate Report at 52-54.

[23] Id. at 34.

[24] Id. at 24-26, 35.

[25] If the off balance sheet transactions and the strategy on which they were based was doomed from the outset (as the Senate Report alleges), whether the CFO and his colleagues profited from the deals should not have influenced their ultimate failure, although it would have saved cash for the shareholders and creditors had Enron rather than these persons retained more cash than it did in the transactions.

[25] In re Enron Corp. Securities, Derivative & Erisa Litig., 258 F. Supp. 2d at 630. Another defendant was not so lucky: a claim was stated against a law firm that helped draft the company's SEC filings, where one allegation was that the filings did not disclose the CFO's profits from the limited partnership transactions. Id. at 620, 664-65, 704-705.

[26] See Senate Report at 8-9.

[27] See Worldcom, Inc. Form DEF 14A (Apr. 22, 2002) (available on EDGAR).

[28] See Senate Report at 28, 32, 41, 43, 45.

[29] Id. at 9-10.

[30] Id. at 33, 35.

[31] Id. at 50.

[32] Id. at 51.

[33] See id. 43 (criticizing lack of disclosure of "high risk accounting" Raptor transactions).

[34] The Enron directors characterized the transactions as involving new and complex issues, and not high risk accounting per se; and believed that they could rely on the outside auditors' expressed approval of the transactions because the auditors had helped design them in the first place. See id. at 19, 57.

[35] In re WorldCom, Inc. Sec. Litig., 2004 WL 2924601 at *48.