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January 20, 2005

Press Contact: Jodi Bart, UT Law Communications, (512) 471-7330.

Why directors' damages may harm investors

by Bernard Black, Brian Cheffins and Michael Klausner
Published January 20, 2005, in the Financial Times.
Reprinted with the author's permission

Earlier this month, former outside directors of WorldCom and Enron agreed to pay substantial sums out of their own pockets in ground-breaking US settlements of class action lawsuits. These deals are a big break with prior experience in the US but they have parallels with legal nightmares suffered by non-executives of companies elsewhere.

The ex-directors of WorldCom, the telecommunications group, and Enron, the energy group, paid out of their own pockets despite the fact that they did not enrich themselves at company expense or know about the frauds that management had committed. Such payments are extraordinary, even by the standards of the highly litigious US. Our research has so far uncovered only a few instances in the US or elsewhere where outside directors paid damages out of their own pockets. No payment has come close to the $13m (£7m) paid by former Enron directors or the $18m paid by their WorldCom counterparts.

The plaintiffs, media pundits and corporate governance experts have hailed the settlements as a victory for investors, saying that they would induce directors to perform better. Not so fast. The settlements could have a salutary effect on board vigilance, but there are two big dangers lurking in these deals.

First, they may prompt an exodus of good people from company boards. According to our research, outside directors already greatly overestimate the likelihood that they will have to pay damages out of their own pockets. The high-profile Enron and WorldCom settlements could have a dramatic impact on an already skittish group, leading well-qualified individuals to walk away from directorships and to decline new posts. Corporate governance could suffer markedly.

Companies seeking to recruit top-flight candidates could increase directors' fees to compensate for such fears, but it is hard to imagine how high compensation would have to be in order to persuade individuals genuinely fearing financial ruin. Moreover, if remuneration became genuinely lucrative, some directors might become too reliant on their boardroom pay and lose the independence that is critical to good corporate governance.

Second, the Enron and WorldCom settlements have worrying political overtones. The lead plaintiffs in both cases were public pension funds. Such funds have been a leading force in pro moting good corporate governance in the US, partly because of their efforts to bring more outside directors on to corporate boards. But because public pension funds are accountable to political officials, there is always the concern that their governance positions may be compromised by politics.

Public pension plans are leading shareholders in all US public companies and have the resources and experience to litigate. If making outside directors pay proves to be good politics, more settlements can be expected, regardless of the governance merits.

There is also a political dimension to some non-US cases. The 2003 prosecution of directors on the supervisory board of Mannesmann, the German telecoms group, though ultimately unsuccessful, was in part a product of fears in Germany that Anglo-American capitalism was not appropriate for a country with strong social democratic values. In Australia, a 2004 settlement under which OneTel's former chairman agreed to pay reduced financial penalties to avoid personal bankruptcy was part of an enforcement strategy introduced by an Australian Securities & Investments Commission chairman with, as one newspaper put it, "a reputation for putting big heads on sticks".

To ensure that capable individuals continue to serve as outside directors of US public companies, public pension funds must establish and announce clear positions on personal liability, and it would be sensible for regulators elsewhere to do likewise. First, personal assets should not be extracted from outside directors except in instances of self-dealing - such as exploiting inside information - or egregious failure of oversight. Second, except in cases of self-dealing, outside directors' personal payments should be limited to sums that leave most of a director's personal assets intact. Bankruptcy is too harsh a penalty for failing to pay sufficient attention.

If US public pension funds and regulators elsewhere announce their intention to adopt this approach now, settlements like those in the Enron and WorldCom cases may indeed foster better corporate governance.

The writers are law professors at, respectively, Texas Law School, Cambridge University and Stanford University.

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