A recent article in the New York Times entitled “The Reckoning: From Midwest to M.T.A., Pain From Global Gamble” caught my attention. The article explains how the boards of various Wisconsin school districts and the New York subway system relied to their detriment on advice from investment bankers. In the case of the Wisconsin school districts, an investment banker convinced five school boards to invest approximately $200 million in collateralized debt obligations. Those districts now stand to lose a good portion, if not all, of that investment. The article quotes one director as saying, “This is something I’ll regret until the day I die.”
The Wisconsin school district story unfolds like a corporate governance exam question. The school boards turned to a local investment banker to discuss alternatives for funding retirement benefits. The investment banker suggested that the boards invest, on a leveraged basis, in collateralized debt obligations (the investments actually turned out to be synthetic CDOs). When asked about the risk associated with the investment strategy, the investment banker reportedly said that “‘[t]here would need to be 15 Enrons’ for the [school] districts to lose money.” One of the directors, a financial adviser himself, acknowledged receiving thick packets of documents but failing to read those documents. The director explained, “We had all our questions answered satisfactorily by [the investment banker], so I wasn’t worried.”
But was the board asking the right questions? The investment banker retained by the boards reportedly had no first-hand experience with CDOs—only a two-hour training session. His company had an existing relationship with the seller of the financial product. The synthetic nature of the CDO investment apparently was not explained or discussed. And the risk assessment appears to have been inaccurate and incomplete at best, particularly if the board relied solely on the investment banker’s explanation.
A board with no understanding of complex derivatives may not know to ask whether the investment is cash-based or synthetic or for an explanation of the reference obligations or ratings process. A board should know, however, to ask about the adviser’s qualifications and experience and for basic data to support the proposed course of action. Now, it may be that the Wisconsin school boards asked these questions and received incorrect or incomplete information. It may also be that the critical information was buried in the prospectus and other materials provided to the board, which board members may or may not have read. Whatever the explanation, a board should understand not only the company’s or institution’s business and industry but also the transactions that the company or institution is undertaking, especially when the board is asked to approve the transaction.
That simple and somewhat obvious conclusion leads me to ask whether boards consciously or subconsciously disengage when professionals or experts provide opinions or recommendations in support of a particular course of action. (For purposes of this post, I am ignoring the structural differences between school boards and corporate boards and focusing on their fiduciary roles.) Having personally witnessed corporate boards grill professionals explaining the particular company’s restructuring options, some boards clearly understand their duty to be informed and to use professionals and experts as resources, not substitute decision makers. For every board that gets it, however, I suspect that several do not.
Most state corporate codes, like Delaware Code section 141(e), protect directors from liability if the directors, in good faith, rely on the “information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.” The Delaware statute and others following its lead contain important qualifiers such as “good faith” reliance and selecting professionals with “reasonable care.” Notably, these important qualifiers often are missing from corporate governance guidelines. For example, the Loews’ corporate governance guidelines state, “In performing its functions, the Board and each Board committee is entitled to rely on the advice, reports and opinions of management, counsel, accountants, auditors and other expert advisors.” Loews is not an isolated example (see here, here and here; others avoid the issue by referring only to a board’s right to retain professionals).
Perhaps the language used in some corporate governance guidelines is just shorthand for what a board is told or presumed to know. The potential risks associated with that shorthand, however, seem to outweigh any burden associated with fully explaining a board’s responsibilities when professionals or experts are retained. Even if a board ultimately is protected from personal liability by an exculpation clause or an indemnification or D&O insurance policy, the board’s blind reliance on professionals and experts may cause irreparable damage to corporate value. Encouraging boards to engage and to challenge retained professionals and experts can only enhance the board’s discussion and ultimate decision. As explained in United Airlines’ corporate governance guidelines, “In discharging [their] obligation, directors should be entitled to rely on the honesty and integrity of the Company’s senior executives and its outside advisors and auditors; nevertheless, the Board must recognize that it has an active, not a passive, responsibility.”
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