Directors Protected From Risk Monitoring Liability

Last week, Goldman Sachs agreed to pay $22 million to regulators to resolve claims that the firm had inadequate policies in place to prevent analysts from sharing nonpublic information with traders.  Reportedly, these questionable “huddles” between analysts and traders were designed to increase trading commissions and influence compensation. 

This settlement highlights the reality that compensation committees are increasingly scrutinized for adopting compensation programs that regulators and stockholders believe are contrary to the corporation’s interests as a result of director action involving a conflict of interest, waste, or failure to exercise business judgment.  The position set forth by the Securities and Exchange Commission was that higher risk trading and business strategies required greater internal controls.

Instructive for corporate directors in this regard are the conclusions drawn by the Delaware Chancery Court in granting a motion to dismiss the claims brought in In re the Goldman Sachs Group, Inc. Shareholder Litigation against Goldman Sachs and its corporate directors.  In the case, Goldman’s compensation committee was criticized for maintaining a program that rewarded executives based on a percentage of the firm’s net revenue, allegedly leading to excessive risk-taking by employees who wanted to maximize short term profits and increase their bonuses.  If the risks paid off and generated profit, employees received a windfall; but if not, stockholders bore the losses. 

The Court made several important points in response to these allegations:

• The committee’s decision to use this compensation model was not wrong or grossly negligent simply because a different metric could have been used to evaluate performance (for example, comparing Goldman’s compensation to that of hedge fund managers rather than to other investment banks).  The business judgment rule only requires that the board “reasonably inform itself; it does not require perfection or the consideration of every conceivable metric.” 
   
• The Court would not conclude that the overall compensation scheme was so one-sided that it amounted to corporate waste.
   
• It was irrelevant that the compensation scheme did not perfectly align executive and stockholder interests, or may have encouraged employee behavior incongruent with stockholder interests.  Changes to the compensation scheme should be effected by changing the directors, not by litigation.

The plaintiffs also alleged that the risky behavior encouraged by the compensation system resulted in unethical and illegal conduct.  This, the plaintiffs claimed, meant that the directors failed to discharge their duty to have systems in place that monitor business risk and legal compliance, contrary to the requirements of In re Caremark International Inc. Derivative Litigation (describing a director’s duty to exercise oversight).   

The Court held that substantial barriers protected directors from liability for a failure to monitor compensation systems:

• Failure to monitor systems that assure legal compliance are within the framework of duties directors have under Caremark.  However, actions that are risky - but legal - are within management’s discretion and are not necessarily indications of illegal conduct.
 
• The Court wrote that “the manner in which a company evaluates the trade-off between risk and return is the essence of business judgment.”  Directors would not be personally liable for making or permitting business decisions that in hindsight turned out poorly for the company.
 
• While the Court acknowledged that a duty to monitor business risk (compared to illegal conduct) is a “theoretical possibility,” for directors to be liable they would have to consciously fail to implement any sort of risk monitoring system or consciously disregard red flags signaling that the company’s employees were taking “facially improper … and not just ill-advised or even bone-headed” risks.  “Such bad faith indifference would be formidably difficult to prove.”

The Delaware courts’ continued recognition that the traditional business judgment rule applies is valuable as directors face increasing challenges to appropriately motivate and compensate executives and make other business decisions in an environment characterized by global uncertainty and risk.

By: Charles M. Modlin and Matthew I. Hafter

Charles M. Modlin is a partner in Seyfarth Shaw’s New York office. Matthew Hafter is a partner in the Chicago office. If you would like further information, please contact your Seyfarth attorney, Charles M. Modlin at cmodlin@seyfarth.com or Matthew I. Hafter at mhafter@seyfarth.com.