Risk Management

How Risky Is Your Board?

The risk of securities litigation is rising, and the boardroom may be the point of greatest vulnerability.
Kate O'SullivanFebruary 16, 2010

For most companies, the risk of securities litigation ebbed somewhat during the past two years, as the plaintiffs’ bar devoted much of its time and energy to complex and potentially lucrative actions against financial-services firms. Now, as the credit crisis wanes, the risk is rising again for nonfinancial companies. Plaintiffs are seeking new targets, observers say, while a reinvigorated Securities and Exchange Commission is also on the prowl, with expanded resources and high levels of motivation following its embarrassing failure to detect Bernie Madoff’s Ponzi scheme.

“Securities class actions will increase not only from the plaintiffs’ bar, but with new legislation being talked about and with the SEC having increased staffing and increased budgets, we’ll also see increased regulatory actions on top of private securities litigation,” says Paul Bessette, co-chair of the securities litigation practice group at law firm Greenberg Traurig. Such common problems as earnings-guidance misses, insider-trading allegations, and accounting infractions will continue to trigger class actions, he says.

CFOs should also look out for corporate-governance weaknesses, say experts. Such weaknesses are red flags for large institutional investors, which are increasingly serving as lead plaintiffs in securities class actions.

“Cases where corporate-governance issues are involved tend to be the largest settlements,” says Ric Marshall, chief analyst at The Corporate Library, a governance watchdog that rates companies on a range of risk factors for securities litigation. “There is not only a linkage between governance failures and exposure to suits, but also a linkage between governance failures and the severity of the settlement.” Nearly all of the top 100 securities class-action settlements since 1996 involve “massive corporate-governance failures,” Marshall says, adding that such cases are often accompanied by “tag-along” suits filed against individual directors and executives.

Two major governance flaws tracked by The Corporate Library are the qualifications of board members and the relationships board members have with each other and with management. The tenure of board members is one of the first places Marshall says he looks for clues about governance weakness.

“If you have 4 of 10 directors who have been there for 17 or 18 years and the CEO has also been there for 18 years, that’s a red flag,” he says. “It means these folks have been working together for a long time.” While such lengthy service should mean board members are extremely knowledgeable about the business, it may also indicate directors have grown too close to management and feel more aligned with it than with shareholders, says Marshall.

Two or more directors serving together on other boards is another red flag, because it shows a degree of coziness between those directors that could be problematic. “Overboarding,” in which a director sits on more than four boards or the CEO serves on more than two boards, also gives Marshall pause. “It suggests that the director is in demand,” he explains. “While that may be reflective of extraordinary skill, it may also indicate that he or she is a bit of a yes person.”

Finally, a review of directors’ biographies can help determine whether they should hold the job at all. “If you go back and look at the Lehman Brothers board, you’ll see that there were two folks on it who were better suited to being on Broadway,” says Marshall. “That was a board whose function was to support and agree with whatever management wanted to do.”

While there is little a CFO can do directly to improve the quality of a board, Marshall suggests reporting the results of regular governance-risk benchmarking to the board. Such a report would include, but not be limited to, benchmarking the board itself compared with competitors or industry leaders. “This is a great, nonthreatening way for CFOs to make the board at least aware of these kinds of concerns,” he says. “Sometimes the best way to facilitate a change is to shine a light on the problem.”